“I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches–representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you would do so much better.”
If you can theoretically restrict yourself to a limited amount of financial decisions over a lifetime, two things will follow:
1. You will study the decisions extensively. All 10-Ks, 10-Qs, Form 4s, scheduled documents (debt documents, employment contracts, etc) will be read. You won’t want to take the opinion of a third-party, you will want to have done the research yourself. You will take the time to think about the business, who their customers are, why they have been able to make a profit in the past and if those reasons will exist in the future. Patient, thoughtful and deliberate are characteristics of this process.
2. After you have gone through such a deliberate and thoughtful investigation, you are not going to throw the proverbial few dollars at the investment, instead you are going to “back up the truck.” This isn’t going to be a 2% position, it may well approach a 20%, 30% or even 40% position. Buffett’s position in American Express (following the salad-oil scandal) amounted to approximately 40% of his fund (see 1963-1965 Partnership Letters). On another occasion, Sanborn maps accounted for approximately 35% of his Fund (See 1961 Partnership Letter). Instead of adhering to the principle of not putting all your eggs in one basket, you will instead choose to put all your eggs in one basket and WATCH that basket…
One caveat to note is that this principle is not meant to actually imply that these positions must be held for life and/or that there are only 20 decisions you can make. In fact, some of Buffett’s very profitable earlier investments (see Rockwood & Co: cocoa beans and Sanborn maps) were essentially investments that had a clear end date and could not be “lifetime investments.” Additionally, Buffett sold his stock in American Express and GEICO, only to buy back into these companies years later. Do these decisions count for two punches or just one? Berkshire owns over 70 companies, in addition to its partial ownership stakes in public companies. I guess he got a few extra punch cards?
A good way to think about Buffett’s punchcard model is to invert the idea of concentrated investments and think about the implications of diversification–a common mode of investment. When someone makes 50 different investments accounting for about 2% of their total portfolio each, you may often come across the line, “Well, the most I can lose is 2%.” This is commonly referred to as the Peltzman Effect in behavioral economics and implies that certain “risk-reducing” decisions (such as diversification, i.e. only investing 2% of your portfolio in each investment) could potentially increase the risks due to the individual engaging in more risky behavior. The risky behavior here is usually the lack of research. Besides, how could you possibly research when you have to come up with at least 50 ideas to diversify your holdings sufficiently.
I am a strong believer in the punch card model. You have to convince yourself that you only have twenty decisions, while knowing that isn’t the case. It’s tough, but it isn’t complicated. Simple, but not easy…