Diversification in equity investing, whilst important, is not the whole story.
What is the difference between diversification and a concentrated portfolio?
Diversification is an important concept in modern investment theory, based on the idea that spreading out your investments reduces risk and volatility. Investments can be diversified within or across asset classes. Thus, a balanced portfolio is seen as one that has a mix of property, cash, stock and bonds with diversification within each of those classes. One would ideally hold both physical and listed property, spread one’s cash across a spectrum of accounts, both on-shore and off-shore, and hold a selection of stocks from different sectors of the market together with government and corporate bonds.
A concentrated portfolio, on the other hand, does not shun diversification although it will be far less diversified in terms of both asset classes held and what is held within each class. Whereas a diversified share portfolio might consist of twenty or more stocks, a concentrated portfolio might hold less than ten. Warren Buffett is known to favour concentrated portfolios.
Which type of portfolio is the best?
This is a difficult question to answer as both types have their advantages and disadvantages. Certainly, unless you have the daring to put all your eggs in one basket (if you do, watch it carefully!), it is wise to have some degree of diversification when investing as it reduces both risk and market volatility. Too much, however, and your portfolio ends up simply mimicking the market.
On the other hand, if you are not sufficiently diversified you could end up with the weakest element in your portfolio sinking the ship in a downturn. Diversification seeks to achieve a balance between your best performing and worst performing stocks in such a way that your overall returns will never be as high as your best performer or as low as your worst.
I have been investing since the mid-nineties and, not initially having much knowledge of markets or confidence in my investing skills, I started off with a completely managed account. As my investing skills improved, however, I took on more and more responsibility for my investment choices and have ended up managing my accounts myself, only relying on my broker for research and market information. Not only have I saved money on fees, I have also gotten a great deal more enjoyment out of investing and the markets.
When I look back on my investment history I see that I have moved away from a highly diversified portfolio to a more concentrated one, which has delivered better returns. My best portfolios have had a strong listed property underpin and I have never had more than ten percent of my entire portfolio in resources. My overall feeling is that whilst diversification provides an important underpin, investing in good businesses that are well-managed is what counts in the long-run.