The benefits of a concentrated portfolio

Conventional wisdom dictates that diversification within a portfolio lowers the overall risk of investing in the stock market.

The majority of advisors and investors are proponents of diversification and shun the idea of a concentrated portfolio as unacceptably risky. So the average actively managed equity fund manager holds over 100 different stocks (some even more than 1,000) and turns over her entire portfolio every year.

But when it comes to the number of equities, too much of a good thing can be a bad idea.

Buy what you know

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.

But how can a manager who invests in over 100 stocks have the expertise to understand each of them? It takes work and dedication to gain a strong grasp on a company’s business.

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.

5 ways to strengthen a portfolio

• Invest in companies you know

• Research, research, research

• Focus on your top investment ideas

• Invest for the long term

• Let the power of compounding take hold

More importantly, when investing in a few 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.

But buy these stocks when the market has priced them below their worth. The gap will 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 to put to work, sizable investments should be made in your top choices—rather than your twentieth, thirtieth or even one hundredth.

Despite the large amount of capital Buffett has to invest on behalf of his holding company Berkshire Hathaway, he still operates on this basis. Looking at his latest company filing (March 31, 2012), you will see he invested over $71 billion in 36 companies.

More importantly, over 90% of those funds are invested in the top 12 holdings. These include Coca-Cola, Wells Fargo, IBM, American Express, Procter & Gamble and Wal-Mart Stores.

Having a large portfolio will not only reduce the negative effects of a decline in a few holdings, but will also minimize the positive effects 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.

It’s counterintuitive to think a sizable portfolio that varies in industry, sector, economy, size and correlation can hinder performance and render returns that mimic those of the overall stock market.

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 andMicrosoft, for example.

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

Time is on your side

Focusing on your best ideas and investing for the long term produce a winning combination. 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.

Visualize a market performance graph; the shorter the time frame, the more pronounced are the spikes in returns.

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, but performance over a quarter or even a year is not articularly meaningful in the accumulation of wealth. After all, you don’t need to win every day; you just need to win over time.

Susy Abbondi is an equities analyst with Duncan Ross Associates.