The great investing myth (5): Concentration versus diversification

There are several famous quotes on having a concentrated portfolio by legendary investors.

If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire vice-chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.

Warren Buffett

“The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.”

Charlie Munger

“Diversification covers up ignorance.”

Bill Ackman

I have always made big concentrated investments. I put all my eggs in one basket and watched that basket carefully. I don’t believe in diversification. I don’t believe that’s the way to make money. You are not going to make money talking about risk-adjusted returns and diversification. You’ve got to identify the big opportunities and go for them.

Stanley Druckenmiller

Risks associated with a concentrated portfolio

Successful investors are able to manage a concentrated portfolio way better than retail investors. It is their profession; they are highly skilled and experienced.

A concentrated investing strategy can generate higher returns with market rally (if right) and sharper losses (if wrong) with pull back and crashes. It is dependent on (1) how much conviction and confidence we have in the stocks selected and our investing/trading strategy as well as (2) the risk we are willing to take.

Our ability to handle wins and losses with a concentrated portfolio is important. Having the right mindset is crucial. The more concentrated the portfolio, the more we can become more emotional and less rational. We can become more biased toward information that supported our thesis (conformation bias) with more at stake. As our portfolio starts to gain more profits,  we can become more greedy and less rational; we may hope for the price to keep going up for more returns. Similarly, as the portfolio loses, we can be rooted in fear and keep holding for hope as the losses in dollar value get higher. Worse will be having a gambling mentality creeping in especially when the market does not go according to plan.

Start small first to get right

Getting started in investing/trading with a concentrated portfolio is risky as we lack the knowledge, experience and mindset. We can easily blow out our valuable capital and shake our confidence.

Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.

Warren Buffett

Yes, it is better to start small to work on our strategy to make it robust and build our mindset and emotions right to handle various market situations before scaling into larger allocations — focus on learning and improving getting with each trade right than winning big. It is analogous to being more careful and safe when we first get our car license than driving fast to get to the destination faster.

Types of concentration

Concentration does not solely mean all into one or a few stocks. We can define concentration in 2 broad ways.

Category 1: Invest a huge percentage of our capital into one or a few companies.
Category 2: Invest a huge percentage of our capital in a specific sector (such as e-commerce, semiconductors, electric vehicles, food and beverages) or a country.

Category 2 is a form of concentration because depending on how wide/narrow we define the sector, the stocks can have the same risks and move in similar directions. In Category 2, we are confident with the sectoral trend with more high-quality companies.  

Key considerations

Personal preference
We must be comfortable having a concentrated portfolio. If a more concentrated portfolio makes us more worried, unable to sleep well and affects our work and lifestyle, a concentrated portfolio will be detrimental. As a retail investor, investing is more than just maximising profits. It has to balance well with other aspects of our lives as a whole.

Managing emotions
As we concentrate on our portfolio, we need to be very conscious of our mindset and emotions. We can become more prone to confirmation bias as our allocation becomes more concentrated. We can easily lose reins of ourselves and the game plan. We shun negative reports and are inclined unconsciously to information that supports our thesis. We may become more stubborn to believe that our thesis is wrong and refuse to change until too late.

Conviction
As we concentrate our portfolio, we need to have a strong conviction that our stocks will deliver the returns. We need to study the stocks in much more detail to ensure we are right as well as their volatility and downside risks.

Types of investments
We need to be aware of the type of investments we are investing in. Investing in early-stage, young high growth potential or high growth companies is riskier than large established companies with years of proven financial records. Hence, it is better to have a more diversified portfolio with younger, high growth companies with limited track records.

Investing in younger, high-growth companies is different too. A few winners can cause an outsized portfolio performance. This will cause the portfolio to “concentrate” as these winners keep doing well with their share price over time.