One of the age-old questions in investing is how widely should we diversify. Unfortunately, it seems that even the best investors can’t seem to agree on this.
Legendary investor Charlie Munger is famous for being a supporter of a concentrated portfolio. He once said:
“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”
In 2017, Munger said that he owned just three positions in his personal portfolio – Berkshire Hathaway, Costco, and an investment in Li Lu’s investment partnership (which itself is highly concentrated).
At the opposite corner, we have other renowned investors who practised wide diversification and yet still achieved stunning results. For example, there’s Peter Lynch, who earned a 29.2% annualised return in his 13-year tenure managing the Fidelity Magellan Fund from 1977 to 1990. In his later years managing the fund, Lynch held as many as 1,400 stocks in the portfolio.
Concentration and the risks
I recently had a short conversation with a friend on this topic of diversification. My friend is a proponent of having a concentrated portfolio, believing that we should not dilute our best investment ideas.
I agree that a concentrated portfolio may give you the best chance of higher returns. If you manage to build a sizeable position in a stock that becomes a multi-bagger (meaning a stock with a return of 100% or more), your return will obviously be better than if you had diluted your portfolio with other companies that ended up with lousier gains.
But we shouldn’t ignore the fact that having a concentrated portfolio can also magnify our losses. If your concentrated portfolio included a large position in a “big loser”, or perhaps in a fraud case such as Luckin Coffee, your portfolio-level return will very likely lag a more diversified portfolio.
Higher concentration = Higher variance
According to research by Alex Bryan from Morningstar, there is no real significance between a fund’s portfolio-concentration and performance.
What Bryan’s research did conclude was that more concentrated funds had a wider variance of returns. This means that concentrated funds had a higher chance of “blockbuster” returns but also had a higher risk of ending up with very poor performance. Bryan explains (emphases are mine):
“The risk in manager selection actually increases with portfolio concentration. So, while we didn’t find a link on average between performance and concentration, the dispersion of potential outcomes increases with portfolio concentration. So, really highly concentrated managers can miss the mark by a really, really wide range.
I think the other point to remember is that more highly concentrated portfolios tend to have greater exposure to firm-specific risk, and on average, that’s not well-compensated. So, again, you really want to keep an eye on risk and make sure that the manager that you hire is taking adequate steps to try to manage that risk that comes with concentration.”
How does this relate to the individual investor?
At the end of the day, how concentrated our portfolios should be depends on our risk appetite, skill, goals and ability to take on risk.
The more concentrated our portfolios, the greater the possibility of extreme returns – both on the upside and the downside. Are you willing to take on this risk and can you mitigate the risks with your ability to select stocks? These are some questions to ask yourself.
Ultimately, thinking about your needs, investment expertise, and circumstance will help you decide what level of concentration works best for you.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Costco.