If you ask 100 financial planners the most important concept in investing, my guess is 99 of them will say diversification. I agree with that sentiment for most people, but not for everyone.
Most people, after all, don't lead the world. Most are happy to be led, to let someone else take the risks. Most seek first and foremost to stay out of trouble. It works, but it's not a great way to get ahead.
Diversification is protection against ignorance. If you don't know what you are doing, diversification allows you to benefit from some of the upside while primarily focusing on protection from the downside.
If you don't want to take risks, if you don't know what you are doing, if you don't want to stand out, or if you are unsure of yourself, then heavy diversification makes a lot of sense.
If, however, you do want to get ahead, diversification is the wrong way to go.
The facts bear out this contention. Investors with the best records don't diversify heavily, they stay focused in the areas they truly understand and they concentrate their bets there.
In fact, the firms with the best records tend to hold only 5-10 positions per analyst. As any financial planner will tell you, that's not diversification.
It makes sense, too, if you think about it. If an investor works 250 days a year and 10 hour days, he has 2,500 hours a year to work. If he owns 500 stocks, that's a mere 5 hours a year to understand each stock. If he owns 100 stocks, that's 25 hour per stock per year.
How well can an analyst really know a company he studies for 5 to 25 hours a year in a dynamic, rapidly changing economy? Not very well.
Now, suppose his competition only follows 25 or 10 stocks. That's 100 or 250 hours a year to follow each business. Who do you think knows each business better, understands its competition and economics, evaluates management more thoroughly? The guy who spends 5 to 25 hours per year, or the guy who spends 100 to 250 hours per year?
And that's why I'm a concentrated investor and consider it a virtue. I'm seeking to lead, to get better than average results, to get ahead.
I know I can't compete with investors who spend 20 to 50 times more hours understanding each business, and I take great comfort knowing most of my competitors are less focused than I am.
Don't get me wrong–concentrated investing is not for everyone. It's almost guaranteed to be more volatile, look more risky, and suffer the criticisms of financial planners.
Those who don't want to stand out, take intelligent risks, or be criticized won't enjoy being concentrated. But, for those who do, the rewards are great.
The academics will tell you to diversify, and they will probably tell you that there's no such thing as too much diversification.
It all depends on your objective. If your objective is to match market performance, which, by the way, will beat 80-90% of individual and profession investors, then by all means diversify to your heart's content.
In diversifying, make sure you have all asset classes, including stocks, bonds, real estate, commodities, etc. And, make sure you have subclasses within in those asset classes, like small and large stocks, foreign and domestic stocks, etc. Finally, make sure you keep your costs as low as possible.
But, if you want to out-perform the market, you have to concentrate your investments.
By definition, investing in all the stocks in the S&P 500 will, after fees, never significantly beat a low priced S&P 500 index fund. That seems obvious.
The only way to out-perform the index is to invest heavily in a few stocks that you believe can out-perform the index. Once again, that's definitional.
It makes intuitive sense, too. Is it even possible to keep track–really understand and accurately assess the value–of 500 stocks? Not in this world.
It doesn't seem reasonable to expect your 21st, 51st, 101st, or 501st idea to be as good as your top 5, 10 or 20, either.
It makes as much sense empirically as it does intuitively.
The folks who out-perform the market–really out-perform after fees by a worthwhile margin–are always concentrated on less than 50 or, more likely than not, 20 stocks.
And, they probably size their positions to correspond to the return and probability characteristics of the investments they make. By that, I mean they buy more of the stocks they believe have a high probability of getting outstanding returns and buy less of the stocks they believe have a lower probability of achieving merely good returns.
If you don't believe me, look at Warren Buffett, or Bob Rodriguez, or Wally Weitz, or Bruce Berkowitz, or Glenn Greenberg.
Warren Buffet recently said that if he were managing $50 – $200 million right now, he'd have 80% in the top 5 stocks and 25% positions in the top few. If you aren't as good as Warren Buffet, you probably don't want to be that concentrated, but you get the idea.
Do you have to have conviction to invest this way? You betcha!! And nothing hones your investing focus like putting a lot of your money into a few stocks.
I've been investing this way for over 12 years now, and I've been quite happy with the results. I've beaten the market by a significant margin (past results are no guarantee of future performance), and this has allowed me to grow my net worth quite quickly.
If you want to match the market, diversify broadly and do it with the lowest fees possible.
But, if you want to beat the market, you should concentrate.
Money managers who concentrate on a few well-researched ideas beat indexers and money managers who are closet indexers (those who mirror the index closely and try to tilt their portfolios in one direction or another).
Although I've long known this, it was nice to see this confirmed in a recent academic article.
The authors of the article created a unique measure for finding out how actively a money manager differs from an index.
Their research results indicated that money managers who differed significantly from an index in their holdings had a significantly higher chance of out-performing the index.
This may seem obvious to you, but many managers try to avoid risk by hugging an index. Such managers do this because they lack the skill to pick the best companies to invest in. Unfortunately, these managers still charge active management fees. Not surprisingly, their lack of conviction leads their investor to under-perform the index after fees.
This just goes to show what I always tell people: you should either index to match the market at minimum fees or find an investor who can beat the market after fees. Such managers are rare, but, if they can out-perform an index over the long term, they not only pay their fees, but lead their clients to reach significantly higher levels of wealth.