Conviction can be dangerous. What I mean by that specifically is that conviction can lead someone to take on more risk than is prudent. Why am I writing about this now? Well, recently I learned that some people who frequent this board have portfolios of 2 or 3 stocks. I’ve heard some justify that high concentration by saying something along the lines of “when you know, you know and when you know then you need to take action.” I’m paraphrasing but what people are really saying is that “I have very, very high conviction and I’m going to take a huge position based on that conviction”. But in actuality no one can know all of the risks that are specific to a single company. There is always firm-specific risk. There are many examples where such firm specific risk was unknown. Enron. Worldcom. Tyco. The most dangerous unknown risk is fraud because it is a risk that can reduce your investment to zero overnight. Now there may be some rare situations where have one or two stocks in a portfolio can be ok. Maybe when one is first starting out and has little wealth is one example. But I would argue that it is a very bad idea to have such a portfolio and here’s why. First, success with a concentrated portfolio (I mean less than 4-5 stocks) will likely lead to continuing this approach in order to repeat the successes. This will lead to a bad habit of maintaining high risk on one’s wealth for an extended period. Success can also lead to overconfidence which makes it likely that a person will be blind to the risks. Another important risk is that if you repeated maintain a concentrated portfolio in different companies over time (i.e. switching the concentration to different companies at times) then you only need to be “wrong” one time in order to have a catastrophic outcome in which a majority of the wealth is destroyed.
Furthermore, conviction can be enhanced by putting more effort into thought and analysis. You can research the market, the competitors and you can build models to predict future earnings. This all can increase your conviction but it can also draw you into the idea that you know more than you can actually know. If you then allocate more of your wealth to investments than is prudent then you may be taking on more risk that you realize. I have personally experienced falling into this trap. In the period from January 2015 through early August of that year my portfolio had risen by more than 70%. I was using stock options to enhance my returns and things were going very well. In the early Summer I begin building models to predict future earnings growth and and stock price ranges off of those earnings predictions. My assessment was that in spite of the gains that I had already seen, my stocks will still quite undervalued. Saul was also saying every month that due to the 1YRPEG on the stocks the portfolio was not a risky one. I very much agreed with him. In August of 2015 stocks started dropping and this was when I started adding leverage by taking out some debt against other assets (real estate); in addition, I began using bull spreads to invest more. As a result my portfolio was now leveraged…something that I had not done before in my many years of investing. As my stocks dropped, I became more and more convinced that my stocks were a better bargain and I continued to add leverage as my stocks declined. By then end of 2015 by 70% gain had turned into a loss and in January 2016 the crap hit the fan. The unconceivable happened. Most of my stocks were down 30-60% from their August highs while then overall market was down less than 20%. This is something that I could not have imagined when I was adding to my positions in the late Summer of 2015. How could ALL of my stocks drop so much since I was diversified. Well, it happened. Unfortunately, I could not ride out the decline in my stocks even though I was convinced would recover because the margin calls began. I was forced to liquidate positions in late January and February. The damage to my portfolio was severe, and I expect that I won’t fully recover to my August 2015 peak for another 3-4 years assuming that I continue to have good results going forward. I was absent from this board for most of 2016 because I took a break from investing. I learned some valuable lessons and I am now back to investing, still aggressive but without leverage so that I can ride out the future downturns. I learned some very valuable lessons, one of the most important being that conviction can be dangerous.