Concentrated or Diversified Portfolio.

Depending on how you use it, Twitter can be Good / Bad or Ugly. For me, it has been an interesting minefield of information on a variety of subjects that hold my interest. One of things I keep stumbling about is when a guy says, ABC share has returned 5X returns in Y years. A secondary thing I keep hearing is that equities have given great returns – this is generally calculated by using 1979 as the base and calculating the CAGR returns from that point of time.

Both in a way are bandied about as to why Equity is the best place to invest. While I agree, one should invest in equities, there are several issues with the above statements which I want to explore more via this post.

There are two ways of building a portfolio

1. A Concentrated Portfolio of a few select stocks (or more stocks but with one or two having unequally high weight).

2. A well diversified portfolio of a large number of stocks

Both come with its advantages and disadvantages. Lets first deal with the Pro’s and Con’s of a Concentrated Portfolio

Lets start with this cheesy quote by the Oracle of Omaha

If you have a harem of 40 women, you never get to know any of them very well – Warren Buffett

The advantage of holding a concentrated portfolio is that you have a very low number of stocks / industries you need to understand. We all have our limitations, both in terms of time and knowledge and its impossible for any one person to know everything that is needed to know about every industry / sector / company that is listed.

The second advantage of having a concentrated portfolio is that even if 1 or 2 stocks click big, the out-sized position size means that the net affect on the overall portfolio will be pretty huge.

Peter Lynch made his name managing the Fidelity Magellan Fund. Over the 13 years he managed, he grew (both in terms of AUM & Net Returns) exponentially. The number of stocks he had when he exited the fund as the manager – 1400+ (Yep, One thousand Four Hundred) (Source: http://bit.ly/169mypw ).

The biggest advantage of having a large portfolio – no one or two stocks can damage the portfolio badly .But on the other hand, even if a stock goes 5x from your purchase price, the net impact on the portfolio may be very negligible.

The larger the portfolio, lower is the volatility of returns. A large enough diversified portfolio more or less starts to mimic the Indices both in terms of returns and risk.

So, what is better?

I believe that the final call on what approach is best is dependent on how much of confidence you have in your ability to pick stocks as well as your ability to absorb the pain that comes in with it.

But if you believe that you do not posses the skill set to identify stocks and bet big on it (Concentrated), you may actually be better off investing into a diversified Mutual fund while concentrating your efforts on understanding the larger picture so that you know when you should be Sipping (in other words, following a Systematic Investment Plan) and when you should be Whipping (Systematic Withdrawal Plan).

And before I conclude, just remember that there is no Free lunch in markets. Its all about give and take. Knowing what you are willing to give will also give you a idea on what you can take 🙂