How To Build a Portfolio – Concentrated or Diversified?
Building a portfolio consisting of quality business is the most important job of the investor. Building a portfolio takes time because we may not get all quality company at the same time and portfolio construction is a lifelong process in the investment journey. Everyone wants to create a portfolio of companies that can outperform the market index all the time but sadly such portfolio rarely exists. We have to accept the fact that, we cannot always outperform the market and we may have to face some years of underperformance also. Think of Buffet, who underperformed the market for many years yet he managed to make billions of dollars.
Portfolio – Concentrated or Diversified
If you look at a list of the richest people in the world, they are single stockholders. They have extremely concentrated their holdings into only one stock. E.g. Jeff Bezos in Amazon, Mark Zuckerberg in Facebook, Mukesh Ambani in Reliance Industries. But investors should not take any wrong conclusions by saying that, in order to get wealthy, we need to concentrate our portfolio to only 1 or two stocks. If we stake our entire net worth in only one stock and if the business doesn’t deliver then our capital may be wiped off.
Investors generally go for the concentrated portfolio because of the asymmetric return that investors would get.
Investing in 1-2 stocks may provide an asymmetric upside. For example, if you invest Rs 100 in only one stock, the maximum downside is Rs 100 (only 1x) but if that stock turns to be a multi-bagger then the return maybe 3x or 5x or even more. In case if you diversify, the returns would be diluted.
But there is a serious flaw when one thinks only of upside potential while investing in a concentrated portfolio.
Investors should focus on downside potential rather than upside in a concentrated portfolio.
Let us consider two stocks and their last five-year performance
Which stock has performed better?
Stock B has outperformed Stock A
This may be surprising because if you look at the table closely stock A has outperformed Stock B in the last four years but overall stock B is the winner.
Reason for why did Stock B outperformed Stock A
The reason is interestingly very simple. Stock B had a minimum downside than Stock A.
If you had invested Rs 100 at the beginning in two stocks, you would have ended up making Rs 174 in stock B and Rs 161.7 in Stock A. Even though, Stock A has outperformed stock B in four years by huge margins, a single year downturn led to overall underperformance of the stock A when we analyze for 5-year period.
Key take away for investors
Focus on downside risk rather than upside risk while maintaining a concentrated portfolio and if we cannot to some extent approximately calculate the downside risk, investors should diversify their portfolio.
Diversification reduces single stock risks. If in any case, any one of the stocks in our portfolio falls severely then, an overall portfolio would not be severely affected. In concentrated portfolio we focused on downside potential likewise in diversified portfolio investors should be focused on upside potential. But most investors do the opposite, they focus on the upside in concentrated portfolio and downside in the diversified portfolio.
Diversification – example
Let us consider we have a corpus of Rs 100 and decide to invest in 10 different stocks. Thus, we invest Rs 10 in each of the stocks. If in a case due to any downturn 5 stocks in our portfolio decreases its value by half and the rest of the stocks doubles its value, then overall our portfolio will be up by 25% (our initial capital of Rs 100 will become Rs 125). Diversification helps us to reduce the individual stock rise since the risks are spread over many stocks but in a concentrated portfolio, risks are extremely concentrated and if the individual stocks don’t work then the overall portfolio gets damaged.
Investors may have a high conviction on some stocks and may only buy a few companies thinking that they may grow multifold in the future. But this approach can be dangerous. Investors must focus more on downside risk when building a concentrated portfolio and while building diversified portfolio investors should focus on the upside.
Now let’s hear what Warren Buffet has to say about Concentration and Diversification