Consider a concentrated portfolio

You’ve heard the refrain before and will again: diversify!

Diversification reduces your risk. Concentrated portfolios are seen as unacceptably risky. But when it comes to the number of equities you hold, too many can in fact be a bad idea.

Buy what you know

Warren Buffett is a celebrated advocate of a concentrated portfolio. He suggests, ‘‘an investor should act as though he had a lifetime decision card with 20 punches on it. With every investment decision his card is punched, and he has one fewer available for the rest of his life.’’

Think of stocks as ownership stakes in privately held businesses—a great deal of research and due diligence is warranted.

Diversification seeks safety in numbers, but deep knowledge and understanding of a company’s financials, products, suppliers and customers will mitigate the risk of holding a few investments.

More importantly, when investing in fewer companies, there’s no need to compromise on the quality of the investments you seek. All of them can be economically sound businesses possessing sustainable competitive advantages and great management teams.

By buying these stocks when the market has priced them below their worth, you’ll create a cushion of capital protection and greater upward potential.

Big bets, big rewards

Understanding company details allows you to determine which investment ideas have the greatest profit potential. If you have capital, sizable investments should be made in your top choices—rather than your twentieth, thirtieth or even one hundredth.

Despite the large amounts of capital Buffett has to invest on behalf of his holding company Berkshire Hathaway, he still operates on this basis. As of his June 2015 company filing, he invested over $128 billion in just 47 companies.

While having a large portfolio can reduce the negative effects of a decline in a few holdings, that’s not the only side effect. It also minimizes the upside of a few outstanding performers.

When investing in a wildly diversified portfolio of stocks, you are making a wager on the general performance of the market, rather than on the potential of individual companies.

The greater the number of stocks in a portfolio, the greater the likelihood of performing like benchmark indices.

Some of the wealthiest people in the world have made their fortunes with just one stock—take Bill Gates and Microsoft.

Or just ask the earliest investors of Berkshire Hathaway, now millionaires. Aside from making a wise investment decision, the underlying factor to their investment success is inactivity.

Time is on your side

Although concentrated portfolios deliver better returns, they also experience greater volatility over the short term.

Volatility is often equated with risk, but the real risk of investing is the potential for permanent capital loss. By extending the time frame for which stocks are held, you automatically reduce this risk.

The longer the time period, the smoother the roller-coaster ride, as the extreme ups and downs disappear and the overall upward trend becomes clear. Holding a few choice investments with conviction will carry you through the short-term market swings and result in a low turnover portfolio, which minimizes both transaction costs and taxes. It also allows the power of compounding to take hold.

A concentrated portfolio may be out of step with the general market philosophy, but performance over a quarter or even a year is not meaningful in the accumulation of wealth. After all, you don’t need to win every day; you just need to win over time.