Concentration versus Diversification

How you can have both

The concentration versus diversification argument is as old as investing, but it’s as relevant today as it was hundreds of years ago when the proverb “Don’t put all of your eggs in one basket” was coined.

Today, diversifying your portfolio is easier than it has ever been, but not everyone does it.

There are many reasons for both diversifying and concentrating, and even when you pick one or the other, it’s still helpful to know just how concentrated one can be without taking on undue risk.

Why you should diversify

I would think that the reason to diversify would be obvious, but I’ll state it out loud:

You do not know the future

Investing is risky, and even when you do all the due diligence you can, and you select high quality businesses with durable competitive advantages, things can and do go wrong.

It’s not unusual for companies to go bankrupt, and even if they don’t go bankrupt, they may simply be operating without ever achieving the returns that you’d expect from them when you first invested.

By holding a whole basket of stocks, you can diversify away the risk of any individual company’s failure to perform.

Value investors such as Benjamin Graham recommend to own around 40 different stocks in order to be suitably diversified, while others recommend more, or fewer companies depending on their own experiences.

Ultimately, there is no exact “correct” number of companies to own in order to be diversified, that’s going to depend on the weightings of the companies that you own in your portfolio, your personal tolerance for volatility, how correlated those companies are, among a myriad of other factors.

That said, if you own less than 15 different companies, equally weighted, in your portfolio, you’re probably not particularly well diversified. The same applies if one or more of your companies is more than 7% of your portfolio.

Why you should Concentrate

In the same way that diversification reduces your downside, it also caps your upside.

If you do know the future, then there’s no reason to diversify at all, unless you’re so wealthy that you buying would meaningfully affect the price, and consequently your return.

If you know what the best performing company over the next 10 years will be, why put any money on the second best?

By concentrating your investments in a handful of well-performing stocks, you can outperform the market in general, since you won’t have the under-performing stocks dragging you down.

Of course, like always, the issue is finding the correct companies to own!

This is where most funds fail, and where you will probably fail as well, so be aware of your biases, and make sure to account for them!

How to have both

Personally, I like to have a concentrated portfolio where I own only a handful of individual companies that I’ve done in depth research on and which I am confident will outperform the market over the foreseeable future.

This doesn’t mean that I am against diversification!

On the contrary, diversification is a key part of my portfolio, and a good reason why I am comfortable being concentrated in only a handful of companies!

Currently, about half of my portfolio is composed of VWCE, an ETF that tracks the FTSE All World Index. This index is composed of around 3600 different companies from essentially all countries in the world.

This is a highly diversified index, and by holding this index, I can easily and simply adjust my diversification by simply adjusting how much of my portfolio is in the index.

This is something that Benjamin Graham couldn’t do in his time. Indeed, there were no indexes available for sale when Mr. Graham was investing, hence he had to make do with the 40 companies he could keep up with.

By buying the Index, I don’t have to worry about keeping my portfolio diversified. I don’t have to worry about balancing any given companies allocation, or constantly buying and selling them to make sure I’m appropriately balanced.

This lack of effort in maintaining diversification lets me focus on a few key company’s, that I would otherwise not be able to give adequate attention to.

Simplicity is good.

How about you? How many companies do you own?

What do you use to diversify?

Let me know in the comments below!