Diversification Is a Matter Of Strategy Rather Than Choice
The choice between a building diversified and concentrated stock portfolio has been an issue of contention for decades. Diversified investors have been perceived by certain quarters to be lacking in both conviction and knowledge. I have a different view on this.
In terms of conviction, the typical argument that concentrated investors put forward is that there is no reason to put your monies in your next best holding. William Browne, in his interview with author Ronald Chan in the book "The Value Investors: Lessons from the World's Top Fund Managers," admitted that he chose to diversify because he is not certain which are his 10 best holdings and nothing is sure in the future. This put the spotlight on the issue of what constitutes knowledge. Browne also added that diversification protects investors against adverse movements in any single investment holding, allows them to be less obsessive with their holdings and avoids focusing too much on stock prices.
My view is that conviction should not be measured by the number of stocks you have in your portfolio, but your consistency in adhering to your chosen investment strategy. Successful value investors like Walter Schloss and Tweedy Browne have stayed true to their investing approach for years, and no one doubts their conviction. Moreover, the success of certain quantitative value investing strategies such as net-nets is dependent on a diversified portfolio to effect the law of large numbers and mitigate the impact of individual mistakes and adverse external events.
Diversification may be a surrogate for ignorance, but the question is how well the concentrated investor understands his holdings and whether this level of understanding or knowledge is sufficient reason for putting all his eggs in one basket. The ultimate form of a concentrated portfolio is an entrepreneur who invests all his monies and time into his business. While the entrepreneur has complete control of his business internally, he is not shielded from external conditions and "black swan" events. For a typical investor with a concentrated portfolio, he is an "outsider" with no access to insider information, even if he has a board seat. In addition, even the most powerful activist investor cannot take over the steering wheel. In possibly his last published interview with author Ronald Chan, Walter Schloss reminded investors following Warren Buffett's approach that Buffett was a good judge of people and businesses, in addition to his analytical abilities. Schloss claimed he invested in the way he is most comfortable with because he knew his limitations.
I end my article with a John Maynard Keynes quote: "When the facts change, I change my mind. What do you do, sir?" Your investment strategy should guide your decision on the concentration of your stock portfolio, which in turn should be guided by your personality and ability.