Concentration vs Diversification in Investing. Which should you choose?

Why Concentration?

A common recurring theme amongst a selected number of top investors in the world is that they generally tend to adopt a concentrated investing approach, and it is this concentrated approach to focus and invest in their best ideas, that have led to outsized returns that have enabled them to beat the market.

Diversification may preserve wealth, but concentration builds wealth. Wide diversification is only required when investors do not understand what they are doing. ” — Warren Buffett

At Vision Capital, where we run an investment portfolio of greater than 80 stocks, which tends to have far more investments that most investors have. Seeing this recurring theme and pattern coming up time after time, the thought of concentration versus diversification had always been on our minds.

What Conventional Wisdom Says…

Modern Portfolio Theory argues that unsystematic risk (i.e. random risk, such as country, industry or company risk inherent in an asset) is the only risk that can be diversified away. As we keep increasing the number of investments in a portfolio, the majority of unsystematic risk ends up being diversified away, leaving behind largely systematic risk (i.e. market risk).

Which in simple words, i.e. the more stocks you have, the more your portfolio tends to end up becoming the market (i.e. an index fund or ETF) and you end up having average returns, as risk reduces.

Source: https://slideplayer.com/slide/15395794/

Why not Concentration?

Concentration, especially if your stock portfolios have less than 10 stocks presents three key considerations for us, namely (1) volatility, (2) returns & (3) scalability.

The Unexpected

If you have a smaller portfolio (e.g. 5–10 stocks), the range of outcomes tend to be far larger than that of a larger portfolio (e.g. 20–25 stocks). The Daily price volatility (i.e. standard deviation) of a smaller stock portfolio tends to be higher. If prices are higher, it is a good thing to have and be happy about. But if prices are lower, for unexpected reasons that could be stock specific and beyond your control, such declines can significantly impact your overall portfolio returns.

Cutting your Winners

If you run a concentrated portfolio (e.g. a 5-stock portfolio), when your winners become multi-baggers and become outsized, and could well end up becoming a significant percentage of your portfolio beyond your comfort zone (think 40–60% of portfolio).

When that happens, what most portfolio managers do is that they end up continuously trimming these winners to avoid over-concentration. Winners are important because they tend to contribute to the overwhelming majority of returns. When you trim your winners and reallocate capital to the next lower performing ideas, you are constantly reallocating capital from the winners to the poorer performing winners. The continuous long-term drag from cutting your long-term winners, will eventually impact longer-term investing performance negatively.

“You want to bet on the winning horse, not the next best winning pony.

Not Scalable

The investment strategy that we choose thus has to be largely scalable, as the size of our fund grows. If one adopts a concentrated approach, there is an implicit theoretical limit on how big the fund can grow to become, because one wants to avoid becoming one of the major shareholders of a company.

As the fund size keeps growing, eventually, scale acts against us with the universe of the companies starts to shrink and the size (i.e. market capitalisation) of the companies start to increase.

Because in general, bigger companies tend to have smaller moves and smaller companies tend to have bigger moves, the portfolio ends up having to either (1) cap its fund size and/or return capital or (2) invest in larger companies, which the latter for market weighted benchmarks like the S&P 500, end up eventually gravitating more and more towards benchmark-like returns.

Why Diversification?

Diversification allows us to let our winners run high, and not having to trim them, and water our weeds instead. Diversification allows us to have a peace of mind on any given day, knowing that because no one stock investment accounts for such a large portion of our fund that we would not be able to sleep soundly.

We rather let your winners concentrate in our portfolio, which is very similar to the way many Venture Capital companies (“VCs”) invest in startups. They have a diversified approach with many investments. But the majority of their VC performance is driven by the few winners that turn into unicorns. In our case , it is the winners, the compounders and multi-baggers that does that instead for us thus far, that return 3X, 5X, 10X and 15X+.

More than 80% of our ~80 stock selections had beaten the market in 2020 and again similarly ~80% thus far in 2021 till date. We don’t know what the market will bring, or how the stock prices will be today, tomorrow, next week, next month or quarter even. But one thing that is very likely is that if growth continues, with rising revenues, improving/rising profits and cash flows, the businesses that we invested in, should do well over the long-term. And that’s all we care about and you should too, not market noise.

Ultimately Choose what works for you..

Your portfolio allocation should ultimately reflect your conviction. The size of an investment should be proportional to your assessment of the probability of success and failure. Invest in a way that best suits you, your own investing style and mindset, and you can do just as well.

“Every investor has different investing styles. Peter Lynch owned thousands of stocks, other top investors had from 5, 10 to 20, to 50 stocks, and they all still beat the market. Adopt & choose what works best for you, not someone else’s.”

13 Feb 202 | Eugene Ng | Founder & CIO| Vision Capital

Find out more about Vision Capital where we have beaten the market by more than 4X over the last 4 years: https://visioncapital.group/

Check out our recently published book on Investing, Vision Investing: How We Beat Wall Street & You Can, Too!”. We truly believe that the individual investor can beat the market over the long-run. The book chronicles our entire investment approach. It explains why we invest the way we do, how do we invest, what we are we looking out for in the companies, where do we find them and when do we invest in them. It is available for purchase via Amazon, currently available via two formats, Paperback and eBook

Join my email list for more investing insights. https://visioninvesting.substack.com/

Follow me on Twitter @EugeneNg_VCap or Instagram @EugeneNg_VCap

This article is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions.

We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time.

Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.

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Eugene Ng

Eugene Ng

Author | Investor | Founder & CIO Vision Capital | Investing in businesses that reflect our best vision for our future