There are several famous quotes on having 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 can manage a concentrated portfolio way better than retail investors. They are highly skilled and experienced. They have detailed investing criteria and analysts to analyse their investments very thoroughly such as reading financial reports, analysing and valuing the numbers, conducting surveys, accessing the management, using their products, talking to suppliers, customers, employees and industry experts as well as comparing them to competitors. They filter many potential companies before they find the best investment idea. Most retail investors lack the skills, experience, time and resources to do such thorough due diligence.
A concentrated investing strategy can generate higher returns with market rallies (if right) and bigger losses (if wrong) with pullbacks and crashes.
Our ability to handle wins and losses with a concentrated portfolio is important. The more concentrated the portfolio, we can become more emotional and less rational. We become more biased toward information that supports our thesis (confirmation bias) with more at stake (sunk cost fallacy).
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. We may add as it rallies. As it rallies further, the portfolio may naturally concentrate as a few stocks account for the bulk of the gains. 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 and we may not have a plan when the market is having wild swings.
We like to have a concentrated portfolio when we are right and it rallies. We will hate it when we are wrong and it keeps dropping.
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 hard-earned 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 develop 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 rather than winning big. Do not get greedy. 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. Slow and steady win the race!
Concentration as the result of outcome than action
Concentration can be an outcome but NOT an action. When we invest, there should be proper portfolio management such as x% with each adding up to a maximum of y% of our portfolio. As the share price increases, it will represent a larger percentage of the portfolio; the concentration occurs by itself. It is NOT something to invest in from day 1.
Types and degrees of concentration
Concentration does not solely mean all into one stock. We can define concentration in two broad ways.
Category 1: Invest a huge percentage of our capital into one or a few similar companies that are direct and close competitors to each other.
Category 2: Invest a huge percentage of our capital in a specific sector or sub-sectors or in different parts of the value chain.
Category 2 is a form of concentration because depending on how wide/narrow we define the sector, the stocks can have similar risks and move in similar directions. In Category 2, we are confident with the sectoral trend with more high-quality companies but unsure how the future will unfold and who will be the ultimate winner. We are slightly more diversified in our selection.
Categories 1 and 2 allow some form of concentration beyond having a single stock; avoiding a single stock risk which we may not be aware of.
Key considerations
Personal preference
You do you, I do me.
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. Everyone is different in circumstances, risk appetites, temperaments, emotions, preferences, needs, priorities, goals, levels of understanding and experience in finance, investment, and money management. These affect our decision-making in investing and personal finance. A diversified portfolio is just as good so long as we can make money.
A related post: We are all different so will be our investments.
Shortcuts and greed
Concentrate on hoping to get rich fast rather than being convinced with detailed analysis
It can take a lot of time and work to analyse many companies just to choose a few great companies to invest in. Once they find a good company, they buy and buy more than they should or worse, with leverage. They do not keep looking for better ideas, stop validating their thesis and hope the stocks they bought will rally hard. We may be greedy and choose to concentrate hoping to make more money.
Managing rationality and emotions
As the bets go big, we become more emotional and lose our rationality.
We have to be very conscious of our mindset and emotions, especially during pullbacks and crashes. We become more prone to confirmation bias as our allocation becomes more concentrated. We can easily lose the reins of rationality and the game plan. We shun negative reports and are inclined unconsciously to information that supports our thesis (confirmation bias). We may become more stubborn and refuse to cut losses as we believe that our thesis is right. We may refuse to take profits hoping it to go higher. When a more concentrated portfolio makes us more emotional and biased, it has reached a detrimental level.
Related posts:
The bad and good of greed in investing/trading
Managing losses: A very important skill that investors and traders must have
Conviction and faith
Concentration as a function of conviction and faith
As we concentrate our portfolio, we need to have a strong conviction and faith that our stocks will deliver returns as we expect. We need to study the stocks in much more detail to ensure we are right as well as their volatility and downside risks. To avoid confirmation bias that we may have with a concentration portfolio, it is better to constantly seek alternative views and opinions.
Types of investments
We need to be aware of the type of investments we are investing in. To have a concentrated portfolio of young unprofitable high growth potential, high-growth companies and turnarounds is riskier compared to a portfolio of large well-established companies with years of proven financial records. Sectors like technology, biotech and new sectors (EV, AI, cryptos) are more volatile.
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.
Number of high-quality stocks we can find
If we can find many high-quality companies in several sectors, we can invest in more high-quality companies with our portfolio. This can be possible when we have time and sources to find many high-quality companies and the time to study them in great detail. There is less need to concentrate as we may be able to find many high-quality companies.
Being an individual retail investor
We are limited in some ways. We may not be so thorough in our analysis due to a lack of time, resources and access. Being an individual investor, we can be subjected to emotions and biases that we are not experienced enough to manage and not have someone to coach us. We have to be aware of our respective weaknesses and strengths and manage them well against the market.
