Irish playwright Oscar Wilde had a genius for epigrams. One of his more endearing was this: , “Moderation is a fatal thing. Nothing succeeds like excess.”
Clever, to be sure, but hardly a truism. Most of us can ruminate in short order and advance a list of people undone by excess.
This is certainly true in the investing world, where I’ve seen investors undone by excess – excessive trading, excessive leverage, excessive trend-following. And this might come as a surprise – by excessive diversification.
To be sure, you want to avoid allocating the family fortune to one stock. But if the goal is to wealth-build and to beat the major-market indices, you’ll want to avoid allocating the fortune across a universe of investments.
The fact is, the great investing fortunes are marked by investment concentration – large allocations to a few select stocks.
My favorite value investor, Carl Icahn, lords over a stock portfolio that rarely exceeds 15 issues. Icahn’s strategy is to assume large concentrated positions in a few underperforming stocks and agitate for change.
You can’t argue against Icahn’s long-term success: His investment vehicle, Icahn Enterprises Partners (NYSE: IEP), is up 1025% over the past 15 years. The broad-based S&P 500 Index is up a mere 60%.
Warren Buffett’s most productive years were also his most concentrated. From the mid-1970s through the mid-1980s, Berkshire Hathaway’s (NYSE: BRK.a) stock portfolio rarely exceeded 10 issues. At the end of one year, 1986, Berkshire’s stock portfolio consisted of only three stocks – Capital Cities/ABC, GEICO, and The Washington Post Company.
At the end of 1975, a Berkshire share was valued at $41. By the end of 1987, it was valued at $2,820. That’s a 47% average annual rate of appreciation.
Since then, Berkshire’s stock portfolio has ballooned to more than 40 issues, while its portfolio of wholly owned companies exceeds 50. Berkshire today is a huge, very diversified conglomerate. Performance has suffered for it. Over the past 15 years, Berkshire shares are up only 200%
I don’t suggest whittling your investment portfolio to three stocks. But a portfolio of 10 to 12 stocks can go a long way to improving returns. Surprisingly, such concentration won’t materially increase your risk profile.
An influential 1968 article written for the Journal of Finance titled “Diversification and the Reduction of Dispersion: An Empirical Analysis” revealed that as few as 10 securities can reduce risk, measured as standard deviation, to a level virtually identical to that of the market.
Balance is key. You don’t want to overweight an individual security or sector. Pick the most promising investment from a sector and don’t dilute with a bunch of also-rans. At the same time, buy stocks with opposing interests, which will occur if you diversify across sectors and avoid overloading one specific sector.
I’m a fan and practitioner of concentrated portfolio investing. It’s the only way I know to beat the major market indices over the long haul. What’s more, it puts you one up on institutional money. Good luck finding a mutual fund or ETF practicing diversified concentrated strategy.
Better yet, good luck finding a diversified mutual fund or ETF that consistently beats the major market indices. They are as rare as a Carl Icahn or a Warren Buffett circa 1985.
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