Great Investors Explain: How Concentrated Should Your Portfolio Be?

Concentration, how much is right and how much can you stand in your portfolio?

This is a question all investors face and it is a difficult one. Having a highly concentrated portfolio can be a stressful experience if you don't know the businesses you are investing in well. If you spend time and effort to get to know the companies you are buying, having a highly concentrated portfolio is not a bad thing and may generate higher returns for you over the long-term.

However, I cannot stress enough the fact that if you want to use a highly concentrated portfolio approach, you have to do your research and invest only in those companies which you believe you have an edge.

Put simply; a concentrated portfolio is not risky if you are prepared to put in the extra work. It is dangerous if you make it so by neglecting your responsibilities as an investor.

The best way to reduce risk in any portfolio is to pay detailed attention to your research process. If you don't have time to do this, diversification is an easy way around it, as the quotes below from some of the best value investors of all time explain:

Great Investors Explain: How Concentrated Should Your Portfolio Be?

“Patience … followed by pretty aggressive conduct. It is given to human beings who work hard at it—who look and sift the world for a mispriced bet — that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” – Charlie Munger (Trades, Portfolio)

“I can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things.” – Warren Buffett (Trades, Portfolio)

“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” -- Warren Buffett (Trades, Portfolio)

“Diversification is the most destructive, over-rated concept in our business. Look at George Soros (Trades, Portfolio), Carl Icahn (Trades, Portfolio), Warren Buffett (Trades, Portfolio). What do they have in common? they make huge concentrated investments. You need ruthless discipline. If the reason you invested changes get the hell out and move on.” -- Stanley Druckenmiller (Trades, Portfolio)

“Charlie Munger (Trades, Portfolio) considers that a portfolio of four stocks is a well diversified portfolio. He says, you don’t even need a 5th stock. He goes on to say that if you lived in a small town, and if you owned the best apartment building in town, if you owned the highest quality office building in town, if you owned the McDonalds franchise in town, if you owned the Ford dealership. if you owned this collection of assets, even though they're all geographically concentrated, his perspective is that you will do very well. You will not need to do much else beyond that to have an interesting investing career.” -- Mohnish Pabrai (Trades, Portfolio)

"A key component of our investment strategy is sufficient but not excessive diversification. Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely. These bargain-priced opportunities are selected one at a time, bottom up, which provides a margin of safety in case of error, bad luck or disappointing business results. However, we are always conscious of whether these different investments involve essentially the same bet. If each of our holdings turned out to involve similar bets [inflation hedges, interest rate sensitive, single market or asset type etc], we would be exposed to dramatic and sudden reversals in our entire portfolio were investor perceptions of the macro environment to change. Since we are not able to predict the future, we cannot risk such concentrations" -- Seth Klarman (Trades, Portfolio)

Disclosure: The author owns no stock mentioned.