Our Thoughts on Concentrated vs Diversified Portfolios

concentrated vs diversified portfolio

Recently, we received questions about the out-performance of our portfolio from our readers. Specifically, the questions we received primarily revolves around how we think about portfolio construction and the merits of a concentrated vs diversified portfolio.

In this article, we highlight our views on portfolio concentration, how many stocks in a concentrated portfolio and ultimately answer the question “Do concentrated fund portfolios perform better?”

From our feedback received, we also gathered that most readers wanted to understand why we limit ourselves to only a handful of stocks, thus creating a concentrated portfolio.

We hope this article will highlight the rationale of our approach.

(Please note that the author is an advocate for concentrated portfolio strategies. As such, the article solely reflects our opinion as a retail investor and should not be taken as advice.)

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    How is our portfolio constructed?

    Here’s a quick recap on how we think about constructing our portfolio.

    We aim to own around 10 names and adopt a buy-and-hold bottom-up investing strategy, with a 3-5 years’ time-horizon (or earlier if fair value is achieved). Our current exposure to both US and UK stocks means our goal is to outperform the average total return of S&P 500 and FTSE 100.

    Our investment philosophy reflects our view of the global economy. We adopt a style-agnostic approach, which means we are solely focused in investing in the best companies, whatever the “style” of investing. We employ a bottom-up fundamental investing complemented with a macro overlay.

    Consequently, we are unconstrained in terms of ideas, from a region, industry and style perspective. More importantly, we believe that great ideas are hard to come by, hence, why a concentrated portfolio works well for our particular investment process.

    Portfolio concentration

    One of the questions we often get from readers about portfolio concentration is how many stocks in a concentrated portfolio. Again, from our point of view, bearing in mind the strategy we are running, we think there should be no more than 10-15 names. Internally, we limit ourselves to just 10!

    As retail investors, we argue there are good reasons for this.

    First, as we alluded to earlier, there are only so many great investment ideas out there. Consequently, there is little meaning in investing in your 38th best stock idea. You want to avoid diluting your best performers or alpha.

    Secondly, our investment process is detail, rigorous and requires significant time and effort to perform stock appraisals. Consequently, this builds conviction and confidence in our decision making process. As such, it would appear wasteful to be investing 1% of your portfolio in a stock that you’ve spent a month researching, for example.

    Lastly, the myth of diversification. In today’s world, we come across too many investors obsessed with diversifying their portfolio that it ends up cannibalizing its own return. This doesn’t make much sense, especially for retail investors.

    “Diversification is a protection against ignorance.” – Warren Buffett

    We think Warren Buffett’s quote is particularly applicable to our investment strategy. The key question ultimately boils down to this: Do concentrated fund portfolios perform better? We discuss later in the article.

    Do concentrated fund portfolios perform better?

    The answer is yes, according to University of Technology Sydney’s research. Using US equity mutual funds as its database, the research established that concentrated portfolios achieve the better performance, both on a risk adjusted and absolute return basis.

    Separately, Kayne advisors, a boutique investment firm, also showed that based on Russell 3000 Index, concentrated portfolios outperformed diversified portfolios over the 5-10 years period.

    total returns of concentrated vs diversified portfolios
    Total returns of concentrated vs diversified portfolios based on Russell 3000 Index. Source: kayne.com

    Additionally, in this article by FT, Brian Routledge and Anthony Forcione of State Street Global Advisors also concluded that “high conviction” funds tend to outperform the market over the long term. Similar to our investment framework, investing in a high number of diversified stocks often dilute the impact of fund managers’ “best ideas”.

    To the contrary, Alex Bryan from Morningstar found that there really wasn’t any significant link between portfolio concentration and performance. Specifically, he highlighted that if you measure that based on average returns or based on the probability of beating a category benchmark, there really wasn’t a big difference between the most concentrated and the least concentrated funds.

    In short, there are two sides of a coin. For what it’s worth, it’s important to note that there is a significant difference between institutional investors and retail investors, which is capital. For retail investors, they have 100% skin in the game. This is not the case for institutional investors.

    For fund managers, being concentrated brings forth to increased career risk and potential capital outflows from investors. For retail investors, that’s less of a concern. In addition, the liberty of having “permanent capital” is crucial is making long term investing successful, which further adds to the case of the advantages of a concentrated portfolio strategy.

    The setbacks of concentrated portfolio strategies

    While we are strong advocate for concentrated portfolio strategies, we are also acutely aware of the setbacks and disadvantages. At present, we think there are two key considerations investors should take note.

    Firstly, owning a concentrated portfolio brings higher risk, as the market perceives. Simply put, from a risk chances opportunities to get things “right”. For instance, in the extreme case of owning only one stock, the outcome boils down to either your thesis will play out or not.

    Secondly, concentrated investment strategies generally brings higher volatility. While this may be concerning for some investors, we think retail investors should ultimately be more suitable in coping with higher volatility portfolio. This is because capital is more “permanent” for retail than institutional investors. For example, a period of under-performance or heightened volatility tend to lead to outflows for mutual funds.

    Summary

    We hope that our article lay out the idea about our thought process. In our view, investors who are willing to invest the time and effort in research (or perhaps just read our blog J) should embrace the idea of having a concentrated portfolio.

    For the average investors, who are still interested in diversifying via funds and ETFs, we think a better idea is to own a few concentrated funds rather than one fund that owns a myriad of stocks. This way, you can get the best of both worlds. For example, 3 funds investing in 15 stocks each, rather than 1 fund that invest in 45 stocks.

    Finally, we leave readers with this thought.

    How many of the world’s wealthiest individuals made their money by being diversified?

    Go big (sensibly) or go home.

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