Business/Finance: Are Concentrated Portfolios Worth the Effort?

Minimal diversifi cation coupled with careful selection of individual
stocks can provide adequate risk reduction, but why go to all
this trouble if wide diversifi cation achieves the same thing? While
preserving capital is a high priority, it is not our only objective.
Concentrated portfolios tend to outperform widely diversifi ed
portfolios. In his book The Warren Buffett Portfolio (John Wiley & Sons,
Inc., 1999), Robert Hagstrom compared the returns of large portfolios
(250 stocks) against portfolios of 15 stocks. Only 2 percent of
the large portfolios beat the market, but over 25 percent of the small
portfolios performed better than the overall market.
Keep in mind, however, that concentrated portfolios were also
more likely to underperform the market; thus, we see the importance
of stock selection. Concentrated portfolios allow individual stocks to
signifi cantly impact performance, albeit positive or negative. Wide
diversifi cation limits the amount one can invest in a specifi c company,
but proponents of concentration tend to invest large amounts
in individual companies when research indicates the odds are in
their favor. This can increase risk, but also maximizes gains.
Along with unsystematic risk comes the concept of unsystematic
gains, or “alpha,” as it’s known in the investment industry. This refers
to the gains attributed to an investor’s skill, as opposed to systematic
gains achieved via general market forces (“beta”). A concentrated
portfolio allows us to select more judiciously, to thoroughly understand
the companies, to respond quickly and powerfully to opportunities,
and to take advantage of tax effi ciencies when buying and
selling.
We’re in good company with our preference for concentrated
portfolios: master investor Warren Buffett (Berkshire Hathaway
[BRKA]) also believes in holding a small number of excellent companies,
procured at discount prices. When the subject of concentration
comes up, we usually quote Buffett, who offers the following
comment:
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 profi t
potential.1
Why indeed.
Careful selection makes a concentrated portfolio work. First of
all, an entrepreneurial investor seeking to limit potential losses requires
a margin of safety, such as tangible assets or a strong competitive
advantage. Reducing the likelihood of losses also helps to
magnify the effect of strong performers within the portfolio.
In any given year or two, a concentrated portfolio can generate
strong results from the performance of only one or two stocks, because
care is taken to bet big when the odds are in the investor’s favor.
In the example above, Wrigley’s (WWY) unfortunate underperformance
has been comparatively small, while ATP Oil & Gas (ATPG)
has performed impressively (see Figure 4.1). If each of these stocks
represented 1 percent of your portfolio, the impact would have
been minimal. But in a 15-stock portfolio, each might represent 5 to
15 percent of the total, in which case the Wrigley loss is still trivial,
but the ATP gain is signifi cant where it counts most: in dollars.