Benefits of a concentrated portfolio

In investments, as in life, selective focus and a disciplined approach is the key to success. At any given point of time, there are thousands of companies actively traded on the market and even if only a small percentage of these shares qualified as “good buys”, you would still have a bewildering array of scrips to choose from. 

Warren Buffet is a proponent of the “concentrated portfolio” theory. He believes that a portfolio should not have more than 10 to 12 scrips. He says “I cannot understand why an investor elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and present the least risk, along with the greatest profit potential.”

John Maynard Keynes, the celebrated economist, echoed these sentiments when he observed “As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

Let us list out the advantages and disadvantages of a ‘concentrated portfolio’.

The advantages:

(i) Better research:

When you are forced to put a meaningful sum of money in one share, you are forced to do better research as to the prospects of that share. In a diversified portfolio with several scrips, where the amount invested in each scrip is small, you are lulled into a false sense of security that even if your decision to invest in that scrip was wrong, the consequences will not be that bad. It is better that you take an informed call than that you blindly put in money.

(ii) Focus on performance of each share:

When you have only ten shares to look after, you know exactly what each share is doing. You have your eye on what your average cost is, what the present price is and where it seems to be headed. It is easier to decide whether to hold, accumulate or dump that share.

(iii) Better returns:

If your research was proper, the results of your investment would yield better returns. In a too-diversified portfolio, even you had your share of winners, the returns would get diluted because your holdings in the winners would be small.

Disadvantages:

(i) Risk concentration:

The greatest criticism against concentrated portfolios is that it maximizes risk. E.g. suppose you have invested heavily in Enron. One company’s downfall can wipe out a large portion of your portfolio.

(ii) Too dependent on choosing the “right” share:

If you had to choose between Reliance and L&T or between Maruti Udyog and Tata Motors, what if you picked the wrong one?

Conclusion: The truth is in between. Obviously one cannot put all of one’s eggs in one basket. Diversification is important. But how much? A selection of 10 – 15 scrips can provide the balance between concentration and diversification without compromising returns.