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Concentration Versus Diversification. Or Both?

While we favor concentrated portfolios, we still believe in the benefits of diversification. Putting too many eggs into one basket raises the risk of wiping out most, if not all, of an entire investment. The question is how many stocks would reduce as much of the company or industry-specific risk as possible, but, at the same time, still provide an opportunity to deliver market-beating returns?

This is a much debated issue. In a 1968 study, Evans and Archer concluded that a portfolio of 15 randomly chosen stocks would be no more risky than the market as a whole. Recent academic research, however, indicates that upward of 40 or 50 stocks may actually be needed, because stocks are a lot more volatile than they used to be.

That said, we don’t measure risk in the same manner. While academics consider volatility a bad thing, we embrace it, because volatility provides more opportunities to buy stocks at low prices and to sell them at high prices. When it comes to risk, we’re much more concerned about a permanent impairment of capital, than mere volatility. We believe our strategy of focusing on select stocks with durable competitive advantages, which trade well below our intrinsic value estimates, helps to minimize that risk.

In addition, we do not randomly select stocks, as the academics do in their studies. Our Select Equity Portfolios generally consist of stocks from a variety of industries, with a diversity of investment characteristics. While we may overweight or underweight certain industries or sectors, based on their relative attractiveness, we do not “bet the farm” on any individual stock, industry, or sector.

We’d also note that Select Equity portfolios generally include several global mega-cap stocks. These firms have multiple business lines selling numerous products/services in various geographies to a broad base of customers. They offer more diversification than the typical stock. So, there are many more factors to consider than just the absolute number of stocks. We believe our approach of investing in 20 to 40 of our highest-conviction stock ideas across numerous industries provides sufficient diversification for the equity investor, but still retains the potential for attractive returns over the long run.

Don’t Take Our Word for It

Several legendary investors as well as a renowned economist also favor concentrated portfolios. We share some of their thoughts on this subject below:

(The opinions expressed below are those of the authors and are not necessarily those of the Morningstar Investment Management group).

“In my view, it’s best to own as many stocks as there are situations in which (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research … There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors. That said, it isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios, I’d be comfortable owning between three and ten stocks.” -- Peter Lynch

“We believe that a policy of portfolio concentration may well decrease risk, if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.” -- Warren Buffett

“Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself. If the investor owns stock in so many companies that he cannot keep in touch with their managements directly or indirectly, he is rather sure to end up in worse shape than if he had owned too few companies. An investor should realize that some mistakes are going to be made and that he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding.” -- Philip Fisher

“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises, which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time, in which I personally feel myself entitled to put full confidence.”

-- John Maynard Keynes