Skewness

This NY Times article about a huge sale of art from the estate of dealer Ileana Sonnabend reminded me of the importance of skewness to investment returns.  Skewness is a mathematical term describing the tendency of a few winners to dominate the investment results of a portfolio, even a well-diversified one.

As described in the article, Sonnabend bought and sold many artworks during her lifetime, but she was also a collector, amassing hundreds of works herself.  Not only that, but she held on to those pieces.  This collection is now worth over $1 billion.  Surely one of the great investment records of all time, leaving aside the question of whether art in general is a good investment. 

What caught my eye though is the fact that the works of only one artist, Andy Warhol, plus one sculpture by Jeff Koons, comprise almost 30% of the portfolio's current value.  It's highly likely that these works represented a much smaller percentage of the cost of the portfolio.  Rather, Sonnabend played a sort of art venture capitalist, assembling a "diversified" portfolio of many artists, well before they became legends, guided by her own tastes and discernment.  Unlike venture capitalists, however, she held onto her winners:  no payouts at the end of seven years, no periodic rebalancing of her portfolio.  The end result was spectacular--I'd bet anything that her "accidental" investment record bettered that of most of her financier clients!

Many newly rich and liquid individuals and family offices are tempted to "play it safe" when investing their capital, sticking to cash, bonds, or index funds.  After all, the desire to diversify probably was a factor in your getting liquid--i.e. selling your business, cashing in your options, etc.--in the first place.  Following that logic, you might not think it makes sense to allocate even a small portion of your capital to "sexy" investments like hedge funds, private equity, venture capital, etc.  After all, what difference can it make if you only put 10% in these kinds of investments?

The math of skewness shows that even small allocations to higher potential return investments can pay off in an outsized way, assuming

a)  You can find a few winners.  You don't need that many
b)  Your winners significantly outperform the rest of your portfolio
c)  You let your winners ride.  This is especially true of investing in investors--e.g. hedge fund managers.  If you manage to find a good investor at a young age, you can ride his results for 20 years or more.

Skewness means that as your winners win, they over time comprise an ever larger percentage of your portfolio.  If for instance you allocate 10% of your portfolio to a "winning" investment that returns 20% compounded over 20 years, while the other 90% of your portfolio, the "safe" part, earns 10%, then after 20 years your winner will comprise 39% of your portfolio.  Your total compounded annual return will be 12.1%, and, most importantly, you'll end up with nearly 50% more capital than you otherwise would have if you'd just put 100% of your original portfolio in the safe bucket. 

Now you again have the wonderful problem of worrying about the concentration of your portfolio.  So sell it all in order to diversify (or tell the grandchildren to), and start all over again.