By now I’m sure all of you have heard the common (and very old) investing mantras. “Don’t put all your eggs in one basket”, “diversification is key to a well-balanced portfolio”, or “mutual funds are a great way to gain diversification for the average investor”. All these quotes have been recycled throughout the investing world, as most money managers and large financial institutions hold diversification as one of their key pillars of what they believe to be successful portfolio management.
The rise in the term diversification typically comes after a significant financial event or meltdown takes place. Times like the dotcom bubble of the early 2000s, or the housing crisis of 2008, and now, the global pandemic and war currently unfolding in Ukraine have all led to the confirmation that diversification is an essential piece of a successful portfolio. If you were to ask any financial professional what the most important concept is when building a long-term portfolio, their answer would almost certainly revolve around proper diversification. So what is diversification? Diversification is meant to mitigate or lessen portfolio risk by guaranteeing that one or a few of your holdings don’t dictate the overall movement in your portfolio. Now, depending on your investment strategy and investing time horizon there can be some benefits to this principle. However, for those who are financially literate, able to manage their own finances, and can withstand short swings in volatility, the premise of diversification is ultimately a losing strategy.
“Diversification is protection against ignorance. It makes little sense if you know what you are doing”
The above quote comes from one of the most successful investors of all time, Warren Buffet. Also known as the “Oracle from Omaha” Buffet has amassed incredible wealth through investing in companies he felt were substantially undervalued by the market. Where many investors look for the next hot trend or promising technology that will change the world, Buffet looks for easy-to-understand business models that trade at attractive valuations. And with this strategy, when he finds a company he likes, Buffet does not shy away from making it a large piece of his overall portfolio.
Below is a snapshot of Berkshire Hathaway’s (Warren Buffet’s company) top 10 holdings. It doesn’t take a financial analyst to see where Buffet has the highest conviction. Almost 50% of his entire portfolio is one company! One company! This is the exact opposite of diversification and would give most money managers nightmares. Berkshire does own substantially more than just 10 companies, however, the other holdings typically only make up 1-2% of the entire portfolio.
It’s not only allocation where Buffet denies traditional diversification rules, his portfolio also shows the majority of his holdings are US-based companies, many within the banking and retail consumer industry. As well, Berkshire owns few other asset classes such as bonds, cryptocurrencies, or commodities. Simply put, the most successful investor of this generation puts his money where he believes shows the strongest potential for future earnings and ignores the rest.
“The winning investor’s objective should be to have one or two big winners rather than dozens of very small profits”
William J. O'Neil, author of the extremely successful book How to Make Money in Stocks describes the faults with diversification, saying, "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, the winning investor’s objective should be to have one or two big winners rather than dozens of very small profits.”
Spreading yourself too thin (mass diversification) is a common mistake investors make, because by doing this, it becomes extremely difficult to stay up-to-date with the company or industry-specific news, as well as substantially reduces your likelihood of beating the market. In the last decade, many have preached the strategy of index investing, touting that investors should simply buy the entire market and be content with average returns. That’s fine if you’re content with average, however, it is unlikely you will ever amass serious wealth through this strategy.
Now of course, if you are going to limit your portfolio to a small selection of holdings, this will require a large amount of analysis and subsequent attention. An investor who does this will need to conduct sound due diligence and truly know the inner workings of their investments. Keeping up to date with earnings calls, forecasts, industry headwinds, etc., become extremely important when implementing this strategy. Also, when creating a concentrated portfolio, remember, you don’t have to do it all at once. Slowly concentrating your portfolio as you begin to understand a company’s business model and future growth prospects is a great way to begin focusing your portfolio while enabling you to constantly reassess your initial investment thesis.
Many envision putting their entire net worth into a select few companies all at once. But these drastic measures don’t need to be taken. Investment success favors those with long time horizons. And those who are looking to create a Buffet-esque portfolio should take their time when determining where to place their capital.
Before continuing, however, I feel an important point must be made. Buffet and many other wealthy investors have been widely successful through concentrating their portfolios. However, this doesn’t mean everyone should rush to their laptops and buy the most obscure cryptocurrency they can think of, in hopes of becoming an overnight millionaire. Buffet meticulously analyzes the risks of his investments and buys assets that have consistent cash flow, sustainable moats, great profit margins, and provide a service or product that is widely used. Each individual will have different tolerance for risk, as well as different views on where their capital should go. Ensuring you have a deep understanding of what your risk tolerance is, where you think the world is going, and how to allocate capital will be more important than ever in a concentrated portfolio.
"The determining trait of the enterprising (successful) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average”
The above quote came from Benjamin Graham, Buffets investing mentor, who was also a large supporter of concentrating one’s investment holdings. The keys to witnessing success from a concentrated portfolio are to take an active role in managing your investments through constantly analyzing and scrutinizing your portfolio, as well as other possible investments. This method is not for your “set and forget” investor. This method is for those who are willing to dedicate themselves to the process and who want to be directly responsible for their financial success. By doing this, you will significantly increase your odds of realizing above-average investment returns.
And with this in mind, perhaps the old saying “don’t put all your eggs in one basket” should be changed to “put all your eggs in one basket, and WATCH THAT BASKET”.