In the investing world, the topic of diversification often arises. As money managers, we advise clients on their stocks, bonds, mutual funds, hedge funds and real estate funds, among others. The intellectual stimulation of this job is hard to beat. We do believe portfolios should be diversified across asset classes. But, when it comes to owning simple common stocks, concentration is the way to go.
My friend David Kaufman recently published an excellent article in the Financial Post on the merits of owning a concentrated portfolio of stocks. David writes for all readers, regardless of their familiarity with high-tone investment language, and his column is worth reading. You can find it here.
David makes a simple point. With the proliferation of exchange traded funds and, I will add, the number of smart people that have flooded into the investment business, it becomes difficult to outperform the stock market.
Investors who have the competency to analyze a small number of stocks in detail and the ability to identify low-priced, outstanding businesses, have the highest chance to outperform dramatically. As billionaire investor Charlie Munger put it, “wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”
Obviously, the fewer stocks there are in a portfolio, the less it can resemble a broad index. The real question is whether a concentrated portfolio increases risk. Many statistical and academic studies have been published confirming that the benefits of diversification are minimal somewhere around the 20th stock. But, I want to keep my analysis to more common logic.
Investment counselors, like everyone else, have a limit on the amount of information they can process. How can one person know enough to own a moving portfolio of 100 securities and always make smart decisions on each one? There is a limit to the number of companies a person can realistically follow and have a strong grasp of the business’s economics.
Looking at it a different way, there are not an unlimited number of good ideas. In fact, there are very few. When a good idea comes along, you are far better off owning more of it.
A concentrated portfolio may also be less volatile. For example, within our small investment group, we do not love resource stocks. Our portfolios tend to exclude the resource companies that make up a large percentage of the Toronto Stock Exchange. In this case, while there are fewer stocks, the portfolios tend to experience only a portion of the market’s volatility.
Wealth is created through concentration and preserved through diversification. Concentration has been the mantra of success for most business gurus from Warren Buffett to Ted Rogers. Diversification has its merits, but if you are looking to outperform the stock market, try sticking to your top picks.
Jamie Grundman is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Jamie Grundman do not necessarily reflect those of CIBC World Markets Inc. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.