Diversified vs Concentrated Stock Portfolios
Should you diversify or make bets with convictions?
Introduction
Hello Investors! Today I wanted to provide an article on basic portfolio management and help you answer a widely debated topic amongst the financial world. Should investors diversify or run a concentrated portfolio? I will go over some of the pros and cons as well as give tips on how to run both a concentrated or diversified portfolio. In my opinion portfolio management varies based on personality and I do not believe that one strategy is better than the other. For example, my portfolio is extremely concentrated with only 7 long positions, but this is also coming from someone who is selective and picky with everything he does in his life. Due to my selective habits and me being someone who is way more confident than they should be, I run a concentrated portfolio with bets I have done my due diligence on. Now before we jump in, I want to go over the two types of risks to portfolios that we as investors face which is unsystematic risk and systematic risk.
Unsystematic Risk
Unsystematic risk is simply risk to a specific sector or individual company. For example, a pharmaceutical company not getting their drug approved by the FDA; because this only affects one company and not the entire stock market its considered unsystematic risk. Diversification is used to mitigate this sort of risk because if you have your eggs in multiple baskets and 1 of the 10 companies in your portfolio experiences a loss due to unsystematic risk, the loss only carries 10% weight as supposed to 100% weight if you were just owning the 1 company. You may have done your due diligence on a company, but some things such as FDA approval or unexpected damages to equipment, just simply can’t be forecasted.
Systematic Risk
Systematic risk is risk to an entire economy, stock market and/or financial system. An example would be the subprime mortgage crises in3 2007-2009. Systematic risk cannot be diversified because these sorts of risks cause the broader market to fall. Diversified portfolios may reduce the volatility during these hard felt times, but systematic risk generally effects all portfolios, no matter how “all weather” the portfolio is.
Why you Should Diversify
Diversification is a good strategy for three types of investors; passive investors, investors who dislike volatility, or investors who have inadequate knowledge on markets or business. Diversification is as I like to call it an “easy way out” because well-diversified portfolios amongst blue chip stocks or ETFs are generally easy to manage. Investors can close their eyes and wake up in twenty years and see their pretty nest egg they’ve set aside grow. Investors also significantly reduce their volatility through diversifying and almost everyone dislikes volatility with their investments. In addition, diversification is such an easy strategy that it can be explained to an 8 year old and they could understand it. Lastly, diversification increases your margin of error. Concentrated portfolios can often blow up if the manager isn’t careful and lead to mega losses, diversification protects you from these sorts of mishaps. Ray Dalio, legendary hedge fund manager even called diversification the “holy grail” of investing.
Why your Portfolio Should Concentrated
Philip Fisher once said that diversification is “oversold” and the almighty Warren Buffet once said that diversification “makes little sense”. Why do investing legends such as Fisher and Buffet say that about diversification? In Buffettology, a book written by Mary Buffet (Highly recommend), Philip Fisher’s quote was “if you spread all your eggs into too many baskets, it gets difficult to control the eggs”. Warren Buffet and Philip Fisher believe you should have a good understanding of the businesses you invest in and the economics of the sector. When you buy hundreds of stocks in dozens of sectors, you increase the chances of expanding beyond your circle of competence and buying stocks in industries you don’t understand. In addition, if I have a particular knowledge of a sector and I am definitive that a specific company is the best company in that sector, why should I own both the best and second best company in that sector for the sake of “diversifying”? Furthermore, why should I own stocks in industries with bad economics for the sake of diversifying? Lastly, I will leave you with another legendary investor Bill Ackman’s perspective, Bill believes that your first 1-10 stocks picks should be your best performing picks, so why weigh your returns down with another 20 or 30 more companies that could possibly not perform as well. He also said, “no man has ever got rich owning 100 companies”. Although diversification is a widely used strategy, there are skeptics such as Fisher, Buffet and Ackman who are contrary to the Wall Street conventional wisdom of diversifying.
Tips for Diversified Portfolio Managers
Have your most researched and comfortable businesses/sectors positioned with more weight in your holdings.
When taking positions in sectors you don’t know, find industry experts to help initiate your stock pick.
Pick Blue Chip stocks for sectors you don’t understand as much and take more aggressive positions in businesses/sectors you are more knowledgable in.
Don’t over diversify.
Recommended amount of stocks 25-50
Tips for Concentrated Portfolio Managers
Do your due diligence.
Ensure you understand the business you’re buying and the businesses economics.
Refrain from emotional selling and buying.
Be confident, do not let short term price movements let you forget about your reasoning for taking a long-term position in the company.
Recommended amount of stocks to hold 7-10
Conclusion
Diversified portfolios provide increased stability and security while concentrated portfolios provide opportunities for huge payoffs, but both tend to do very well over the long-term so long as the manager is competent. As I said earlier, portfolio management is based on personality and I believe either way you choose to manage your portfolio you should see success. It all comes down to an investors discipline to implement and execute their strategy.