“Behold, the fool saith, "Put not all thine eggs in the one basket" - which is but a matter of saying, "Scatter your money and your attention"; but the wise man saith, "Put all your eggs in the one basket and - WATCH THAT BASKET ."
― Mark Twain, Pudd'nhead Wilson
Some of the best investors, like Warren Buffett, George Soros, William J. O'Neil and Bernard Baruch spoke about the virtues of holding concentrated positions. “Diversification is a protection against ignorance," according to Buffett. "[It] makes very little sense for those who know what they’re doing.”
Think about it - do you have the time to keep on top of dozens of companies in your portfolio? The average person simply cannot pay enough attention to a broad spectrum of stocks in a variety of industries and/or asset classes.
“It is unwise to spread one’s funds over too many different securities," said Bernard Baruch. "Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.”
"The more stocks you own, the slower you may be to react and take selling action to raise sufficient cash when the next serious bear market begins,” wrote William J. O'Neil in his classic book How To Make Money In Stocks. “The winning investor’s objective should be to have one or two big winners rather than dozens of very small profits.”
If you spread yourself too thin, you will compromise your results and your likelihood of beating the market. Many financial writers preach the value of index investing - just buy the whole market and be happy with being average. That's fine if you're aiming for average returns and don't want to bother trying to beat the market. It's unlikely, though, that you will be able to accumulate serious wealth by utilizing that strategy.
"No hospital wings or college dormitories have ever been named by an indexer," said James Oelschlager, founder of Oak Associates. "They've been named by people who invested in one or two stocks and rode them for a period of time."
Of course, selecting stocks for a concentrated portfolio requires a lot of analysis and attention. An investor with a concentrated portfolio needs to put the work in and must know as much as possible about their investments. They should be listening in on earnings conference calls, studying financials and tracking the business environment carefully.
"The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average," Buffett's mentor, Benjamin Graham wrote in his seminal tome The Intelligent Investor. "Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor."
The biggest argument for diversification is protection from risk. By buying a multitude of stocks, it's true that you're lowering the risk that any one stock would fall and wipe out a big chunk of your portfolio. But you're still not protected from overall market risk when the whole market tumbles.
One strategy is to buy a select few stocks in uncorrelated sectors. For instance, you can buy a technology stock and balance that with some consumer staples companies to counterbalance a higher risk sector with a more defensive one. Stocks with lower betas tend to fall less than the overall market during a downturn.
If you have a handful of stocks, you can mitigate some of the risks that will come when macroeconomic factors, such as a bear market or a recession, cause the entire market to fall. If you're knowledgeable about the stock and believe in its long-term potential, you can ride out the storm, buy more stock at discount prices and collect dividends for income until the market turns around.
By buying and selling incremental amounts in a smaller portfolio, you can create sizable positions while ensuring that you're not spending all your cash at peak prices. You can continue to add to these positions when there is weakness and improve your overall cost basis and returns. Even when the stock rises, George Soros thinks that if you believe in the company and their long-term prospects, you should continue to buy more, even at higher prices.
“If the stock goes up, you buy more," said Soros. "You don’t care how big the position gets as part of your portfolio. If you get it right, then build.”
Buffett loves when the market drops, as he is able to buy more stock of the companies he loves at cheaper prices. Forbes interviewed Buffett in 1974 in the midst of a bear market and asked him how he felt. Buffett’s response? “Like an oversexed guy in a whorehouse.”
Obviously, this method of investing is not for the "set it and forget it" type of investor. Those unwilling to put the work in should probably stick to index funds. The price you pay for a diversified, actively managed mutual fund usually results in underperformance due to high fees, even if you invest in a no-load fund.
If you have a financial advisor or money manager who is a fiduciary (and you should), they will most likely be unable to set up a concentrated portfolio, so you'll have to do it yourself. Fiduciaries are legally required to act in what they believe to be in the best interest of their clients. You'd be hard-pressed to find one who would set up a highly concentrated portfolio since it runs counter to conventional thinking.
To repeat, this strategy is only useful if you intend to put the work into acquiring as much knowledge as you can about a few select investments. This is not to suggest that you should put 80% of your life savings into Netflix stock, unless you really understand the nature of their business and have spent the time poring over their financial statements and analyzing the company thoroughly.
If you are willing to put the work in, however, you may be richly rewarded for your endeavor. Better to be like the wise man: put your eggs in one basket and WATCH THAT BASKET!
Karl Kaufman, Contributor