Investors are often told that diversification is the only “free lunch” they will ever get during their investing journey, but there is a strong case to be made for having a concentrated portfolio. 

Although diversifying allows investors to reduce risk, and volatility, concentrated portfolios tend to do better over time. Let’s look at some of the major advantages of having a concentrated portfolio.

What is a concentrated portfolio?

A concentrated portfolio is an investment portfolio that is made up of just a few positions. Investors who research, and deeply understand what is behind each of those positions are more likely to run concentrated portfolios. Concentrated portfolios tend to outperform relative to diversified portfolios, and when compared with the broader market.

Why are portfolios concentrated?

Investors often build concentrated portfolios because they are easy to manage, and are more likely to generate sizeable returns. Instead of focusing on a large number of good investment ideas, it is wiser to select a few excellent ideas, that you are knowledgeable about.

Do concentrated portfolios outperform?

Concentrated portfolios tend to outperform, despite having higher volatility and risk. This is because their returns are dependent on just a few factors, that could make a handful of stocks trend higher. 

To outperform using a diversified portfolio, several things need to happen altogether in order to push a large percentage of the stocks in the portfolio higher.  

What are the advantages of a concentrated portfolio?

The main advantages of a concentrated portfolio are:

  • Requires less effort
  • It takes less time
  • Time-efficient
  • Deep insights into the business
  • Increases the investment commitment
  • Less correlation with the general market
  • Less prone to systematic risk
  • Potential for higher returns
  • Returns are dependent on fewer factors
  • More likely to beat the market
  • Increases focus on a few stocks
  • Avoid related diversification
  • Pick better stocks
  • Easier to average down

Why a concentrated portfolio requires less time and effort

One of the advantages of a concentrated portfolio is that it requires a lot less time and effort. Because an investor with a concentrated portfolio just needs to:

  • Research a handful of companies
  • Track just a few stocks
  • Read the news on just a few topics
  • Read a few annual and quarterly reports

In theory, an investor will take the same amount of time researching a company, whether it has 1 stock in its portfolio or 100 stocks. At least, in theory, it should. Obviously, the investor with a single stock will probably try to understand everything they can about that business.

Why a concentrated portfolio allows you to be more time-efficient and to have better insights?

That is one of the reasons a concentrated portfolio allows you to have more insights into the company and to deeply understand the business. Since you are not researching 30 or more stocks, you can use your time more efficiently. In order to have major insights into a specific business.

Why a concentrated portfolio increases the investment commitment?

Some investors are known to over diversify, or what Peter Lynch would call diworsification. This leads them to add stocks to their portfolio without a lot of commitment. This may be because they are looking to diversify, and a small position in the portfolio will not affect them considerably. 

One of the greatest advantages of a concentrated portfolio is that each position needs to have a highly compelling investment thesis behind it. Since you are committing a high percentage of your net worth into a single stock, you have to make sure that you are making the right decision. 

This leads investors to be more cautious, due diligent, and to dig deep to really understand the business and the risks associated with the investment. Thus, there is a strong bullish case for each of the stocks in the portfolio, which increases the likelihood of generating above-average returns.

Why a concentrated portfolio has less correlation with the general market and less exposure to systematic risk?

A concentrated portfolio will experience less correlation with the general market, which means that it is less dependent on whether the general market is going up or down to move in the same direction. 

A concentrated portfolio also has less systematic risk. This is because there are just a few companies in the portfolio, and reduces the risk of a sudden stock market drop that affects your portfolio broadly.

Why a concentrated portfolio can generate higher returns?

A concentrated portfolio can easily beat the market because its performance is just dependent on a few factors. To understand this better let’s look at an example:

Investor A has a portfolio with a single stock. Let’s consider that in order for his portfolio to generate a 100% return, the stock needs to double its revenues and profits. In order to generate a 100% return he just needs that single company to perform the way he expected.

Now let us consider investor B with a portfolio of 30 different names. In order to achieve a 100% return, this investor needs his 30 stocks to rise by 100%. 

Let’s think of this in an abstract way: 

One single stock going up 100% is much more likely than 30 stocks all going up by 100%. Or even 15 of his stocks going up by 200% and the remaining 15 staying flat. 

This is the key to understanding why extremely successful investors take a concentrated investment approach. Because in order to achieve a certain return they are dependent on fewer factors. This is all based on probability and how the likelihood of several things happening simultaneously tends to be lower than the probability of just a few things happening.

This also explains why a concentrated portfolio is much more likely to outperform or beat the market.

How concentration avoids related diversification and forces investor to be better stock pickers

Oftentimes investors diversify across the same industries. This is what is commonly referred to as related diversification. A portfolio with several stocks in a few industries appears to be diversified, but it isn’t. A concentrated portfolio forces an investor to pick winners in those industries. 

For example, you don’t want to own Ford, GM, Toyota, VW, and Tesla stock. Instead, you want to pick the company in the auto industry that will outperform its competitors. This is very beneficial because it allows investors to focus more on just a few stocks that they own.

It also makes it easier for investors to pick the clear winners in a certain industry, and reduce industry risks that can make your portfolio overnight. Related diversification leads to having correlated assets, that create higher portfolio volatility.

Why a concentrated investment portfolio makes it easier to average down?

A concentrated portfolio makes it easy to average down since there are only a few stocks in the portfolio. Investors that have a very diversified portfolio, and see their stocks drop in price can have a hard time deciding which stocks to average down. 

This becomes especially difficult when you have a large number of stocks in your portfolio, and the market starts dropping. It requires you to understand exactly which stocks you should average down. 

You need to assess exactly which stocks make more sense to average down in that particular moment. This is fairly easy if you have 3 to 5 stocks. However, imagine trying to average down on a portfolio of 30 stocks, it becomes difficult to understand which stocks you should focus on.

An investor with a concentrated portfolio knows exactly which stock he should average down.

How concentrated should your portfolio be?

A concentrated portfolio should be adjusted depending on your risk tolerance, and risk capacity

The concentration level of any portfolio should be determined by your investor profile and risk appetite.

If you are unable to deal with risk and volatility, it is wise to diversify your holdings geographically, and across different industries. If you have a higher risk tolerance, and capacity, then you can have a concentrated portfolio.

The concentrated portfolio analogy

One of the ways investors should think of concentrated portfolios is by using an analogy between your portfolio and a businessman. When someone starts a business, they will invest their capital, put their time and energy into it. 

In a way, their portfolio is made up of a single company. This serves as the perfect analogy for a concentrated portfolio, that might even be diversified across a handful of stocks.

Well if the entrepreneur starting his own business has a concentrated approach, then an investor with a portfolio with a few holdings will be almost the same thing. It is also important for investors to understand that some of the most successful individuals in the world have been entrepreneurs with an extremely concentrated portfolio.

Obviously, it has advantages and disadvantages, but what we are trying to show you is that some investors or business operators have extremely concentrated portfolios, and it works for a reason. 

Risks in a concentrated portfolio

One of the strongest arguments for diversification is the reduction both in risk and volatility. This is not always the case. When we compare concentrated and diversified portfolios, the volatility in a concentrated portfolio will be higher in theory. However, risk is not volatility.

Since you have a lower number of stocks, your portfolio might fluctuate more. But if you are aware of the risks associated with each stock that you own, having a concentrated portfolio actually reduces your risk level.

When you have a diversified portfolio of 20 stocks, there are several risks associated with each one that should be taken into account. If you are not entirely aware of all of these risks for each stock, then it does not make sense to invest in those companies.