Benefits of a Concentrated Stock Portfolio

What are the benefits of a concentrated stock portfolio? What advantages does it have compared to a diversified portfolio?

The concentrated stock portfolio is usually the result of the investor or portfolio manager having many investment ideas and wanting to achieve a high return on the portfolio.

If the investor would invest in all of this investment ideas, then this results in a diversified portfolio with less expected return.

This is due to the following: let’s say the investor has 40 stocks that he thinks are good investments. The investor can then order these 40 ideas by how good he thinks they are. The best idea with the highest expected return on top and the worst on the bottom.

If the investor into each of his best 10 ideas 10% of his portfolio (10*10%=100%) then the overall return of the portfolio will be the average of the returns of each 10 ideas individually. This is a concentrated portfolio.

If the investor invests into each of his 40 ideas 2.5% of his portfolio (40*2.5%=100%), then the overall return of the portfolio will also be the average of the investments. But his time, the average is calculated from all 40 stocks instead of the 10 best. This is a diversified portfolio.

If the 10 best investment ideas perform better than the remaining 30 ideas, then the overall return of the concentrated stock portfolio will be better than the diversified portfolio. This is the benefit of a concentrated portfolio.

However, if the 10 best stock picks do not perform better than the remaining 30, then the concentrated portfolio will not have a better return. At the same time, the concentrated portfolio will have higher volatility because a larger proportion is invested into each of its stocks (10% vs. 2.5%). The the ups and downs of each stock have a larger effect in a concentrated portfolio. And a higher volatility is not good.

Therefore, a concentrated portfolio only makes sense, if the investor can actually pick stocks well and his best 10 stock picks are better than his other stock picks.

The investor must be enough good of a stock picker, that the additional risk he takes by the higher volatility of a concentrated portfolio is outweighed by the higher returns of his 10 best picks.

For many investors, this is not the case. Many investors are not skillful enough in stock picking to justify a concentrated portfolio. Make no mistake, a concentrated portfolio is inherently riskier than a diversified portfolio.

A concentrated portfolio should never, ever be below 8-12 equally weighted positions. This is the lower limit.

I have never read of any of the world’s top investors (multimillionaires and billionaires) going below 8-12 approximately equally weighted investments. But I often read, that they argue strongly against going below 8-12 investments.

In addition, these stock positions should be independent of each other as much as possible. For example, one stock is real estate, one stock is chemical processing, another stock is dairy, etc.

Investing into a concentrated portfolio and failing to invest into stocks that are as much independent of each other as possible can result in very risky portfolios and huge losses. That means much larger losses than the overall stock market up to complete loss.

That is because if the portfolio is concentrated and the individual stocks are dependent, then not only does the drop in the price of one stock produce a meaningful loss for overall portfolio, but all stocks at the same time drop in value and create a large overall loss in the portfolio.

To quantify dependence of stocks to each other, a measure called “correlation” is sometimes used. However, it is a simplification and this measurement may change in up and down markets. So it is best not to rely on it and instead select stocks that really do not have much in common in the business they do in the real world.

For most investors, it is probably better to go with around 20 or more positions, if they desire to have a concentrated portfolio.

To sum up, the benefit of a concentrated stock portfolio is the higher return if the investor is a good stock picker. The disadvantage is higher risk. If the investor is not a good stock picker, then there are no benefits to a concentrated stock portfolio, but only disadvantages.


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