One of the longest-running arguments in the investment world has to be the concentrated versus diversified debate. It seems to me that investors and analysts have been debating the benefits of the two strategies since the early 1900s. It doesn't look as if the debate is going to reach a natural conclusion anytime soon.
Even today, when index funds dominate the market, there is still a considerable number of institutional and regular investors that are devoted, concentrated investors. These investors own just a few stocks in their portfolios.
On the other hand, you have investors who are devoted index fund users. These investors effectively own every single stock in the market and think they are going to achieve strong returns because of it.
Evidence suggests both sides of the argument are right, to a certain degree. On the one hand, you have all of the investors that have made a fortune from just one or two significant investments over the years.
On the other hand, we know that owning an index fund is all you need to do to achieve steady, market-matching returns over the long term. This is probably the best way for the average investor to make money. Numerous studies support this conclusion.
Joel Greenblatt's view on concentration
Joel Greenblatt (Trades, Portfolio) is one of the greatest investors of all time, and he believes in the concentrated investing approach. He spoke about this in an interview with Bloomberg's Masters in Business. This is what he said on the subject:
"Right, well Warren Buffett (Trades, Portfolio) has a good response to that as well. You know he says, listen, let's say you sold out your business and you got $1 million and you are living in town and you want to figure out something smart to do with it. So you analyze all the businesses in town and let's say there's hundreds of business, and you stick to — if you find businesses where the management's really good, the prospects for the business are good, it's run well, they treat shareholders well, and you divide your million dollars between eight businesses that you researched well in town, no one would think that's imprudent, they would actually think that was pretty prudent...
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All of a sudden, if you invested in stocks and did the same type of work, people think you're insane, and it's just an interesting analogy that I was think of when people make fun of me that I was that concentrating."
Greenblatt (and Buffett's) viewpoint here makes a lot of sense. However, it does make the assumption that the level of information available to minority stockholders in large businesses is the same as it would be for small, family-run businesses in a small town. This is not necessarily going to be the case.
This is where I think concentrated investing fails. Many very intelligent, very talented investors have made a lot of money using this strategy over the years. But if you don't know what you are doing, then concentrated investing can be a quick route to bankruptcy.
Conclusion
So, in some ways, I think it is misleading for investors like Greenblatt and Buffett to be advocating concentrated strategies, which are not suitable for everyone.
At the end of the day, it all comes down to your own experience and risk tolerance. This is yet another part of investing that requires a considerable level of emotional intelligence and self-awareness to understand and put into practice successfully.
What's more, evidence shows concentrated investing suffers from a substantial amount of survivorship bias. Investors like Buffett and Greenblatt have made billions investing in concentrated portfolios, but how many other hundreds of thousands of investors have lost everything by betting the ranch on a single investment?
That's something to consider when you are constructing your own investment portfolio.
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