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Build Wealth With a Concentrated Portfolio (Not Diversified)

concentration builds wealth, not diversification

Is there truth behind the saying concentrate to build wealth, diversify to preserve it? In this article I’ll present the case for concentration over diversification, even though the latter is all you hear about.

There are a lot of generally accepted “truths” in the finance and investing world. One of the most common is the importance of diversification.

“You need to have a diversified portfolio.”

You hear it all the time. It’s one of those sayings that has been repeated so often we just assume it’s fact.

As a result, many investors diversify between stocks and bonds. They then diversify their stocks with domestic and international; small cap and large cap, value and growth; developed and emerging markets…the list goes on.

Financial advisors love to push this narrative and extol the benefits of having a diversified portfolio. Some might tell you all you need to do is buy this one mutual fund and you’re set, but look within that fund and you’ll find hundreds of individual stocks.

The harsh truth is that the finance industry runs on fees and misaligned incentives. The more they can convince you to diversify into the newest stock or investment, the more commissions they earn. The more stocks a fund holds, the more it mirrors the overall market’s performance. You can’t get fired for meeting the benchmark, but you can for missing it.

Yes, diversification can lead to reduced volatility. But the more you diversify, the lower your expected returns are as well.

How much annual growth are you willing to sacrifice so you can sleep better at night when the market’s down?

Only you can answer that question. But if the answer is that you’re okay with holding through volatility and temporary price drops, in return for larger overall returns, then consider diversifying less and concentrating more.

If you’re a young investor with a good career and lots of earning potential ahead of you, this point applies to you even more. If you’re passionate about investing and serious about outperforming the market, having a concentrated portfolio with only a few holdings is how you do so.

How I Grew My Wealth With a Concentrated Portfolio

For the past several years, the bulk of my investment portfolio has been comprised almost solely of just two assets: Bitcoin and Ethereum. That’s it.

All I’ve done over the years is to continue buying more through a simple dollar cost average strategy. I held through the 2017 crash from nearly $20K per BTC all the way down to $3K. In hindsight I would’ve liked to have sold near the top, but I missed the chance. What I did instead was buy more in the $5-6K range.

The only way I was able to do this is because of the conviction I’ve built in my investment thesis. I’ve spent hundreds of hours reading and learning everything I could about Bitcoin, Ethereum, and the entire crypto space.

I used to print out whitepapers every day at work to read on the train ride home. When I ran out of whitepapers to read, I listened to any relevant podcasts. I participated in forums. I even got a job in the space to advance my own knowledge.

There’s still much to learn, but it was only after doing all this that I felt comfortable holding Bitcoin and Ethereum through all the volatility.

Professional investors fly out to target companies to investigate how they operate. They’ll walk around their manufacturing facilities. They’ll talk to employees on the ground and ask them how they’re treated and what they really think about the company.

This is the type of effort it takes to develop the conviction it takes to hold a concentrated portfolio. One where you’ll still be able to sleep at night despite 50%+ price drawdowns.

Top Investors With a Concentrated Investment Strategy

Bill Ruane was a legendary investor, with a reputation as one of the most successful stock pickers of his generation. After Warren Buffett closed his fund in 1969, he recommended Ruane as his replacement.

Ruane’s most important investing principle was simple: invest in a small number of stocks and know everything there is to know about them. In 2001, 35% of his Sequoia Fund was invested in just one stock: Berkshire Hathaway.

While everyone else was chasing Internet stocks during the bubble and Buffett had fallen out of favor with investors, Ruane remained true to his principles. Since then, we all know how Berkshire Hathaway has performed.

Nick Sleep and Qais Zakaria of Nomad Investment Partnership are probably names you haven’t heard of, but their investment performance is amongst the top investors.

Between 2001 and 2014, their fund returned 921% versus the 117% benchmark of the MSCI World Index. During this run, there were times when as much as 70% of their funds were held in a single stock.

In 2014, they closed down shop and returned their investors’ money. They’ve since been managing their own money to similar success.

Sleep’s fund nearly tripled within the first five years. The >$175M fund only holds three stocks: Amazon (AMZN), Costco (COST), and Berkshire Hathaway (BRK.A).

Regardless of how big their fund size is or whose money they’re managing, Sleep continues to practice what he preaches with a concentrated investment strategy.

Advantages of Diversification

Reduced Volatility and Risk

The theory behind diversification is to lower risk. If you put all your eggs into one basket and that basket gets destroyed, you’ve lost all your eggs. If you spread your eggs out into several baskets, you’ve still retained some eggs even if one basket is lost.

With most diversified portfolios, the idea is that if one sector or asset class were to suffer, another one in your portfolio would hold steady or even outperform, offsetting the overall impact.

An example of this might be holding consumer staple stocks along with high growth tech stocks. Consumer staple stocks like Walmart or McDonald’s are generally more recession proof than early stage startups with high debt and negative cashflow.

Hands Off Investing

Holding an index fund that tracks the market requires no effort. It’s why index fund investing can be great for those with busy jobs and don’t want to or have the time to monitor their investments closely.

For some people, this can offer peace of mind. You’ll know your money is working for you still, and without the stress of worrying about any individual company or asset.

‘https://www.cnbc.com/2020/02/02/heres-why-diversification-can-be-an-investors-worst-enemy.html

Advantages of Concentration

You’ll Likely Generate Higher Returns

If you look at the investors with the best returns, more likely than not they had concentrated positions. Very few fund managers with diversified portfolios are able to massively outperform the market.

To paraphrase a Buffett quote, if you had five great investment ideas, why would you put money into your 20th best idea?

Many academic studies back this up, as they show time and time again that concentrated portfolios outperform diversified portfolios.

You’ll Make Fewer Emotional Decisions

When you truly know what you own, you’re less prone to making emotional decisions at the wrong time. No one thinks they’ll buy high and sell low, but all too often that’s exactly what happens.

The market has a tendency to shake retail investors out of their positions, just before they go on massive runs up. We can blame manipulation or algos, but at the end of the day if we make the wrong decision we can only blame ourselves.

Part of the reason investors sell at the wrong time is because they don’t really understand what they own. When we don’t really know what we own, we let price dictate how we feel about it.

On the flipside, when we have an informational advantage developed through extensive due diligence, we can see beyond the short term price fluctuations as long as the long-term picture remains intact.

How to Navigate a Concentrated Portfolio

Not everyone has the temperament or desire to want a concentrated portfolio. If you do, here are some recommendations for how to navigate it.

Monitor Your Investments Closely

Holding a concentrated portfolio means you need to keep your eye on the ball at all times. The good thing is if you only have a few assets, it’s much easier to do so.

You should have the ability and desire to keep up to date with any relevant information. If you’re holding stocks, at minimum you should have read the entirety of the company’s annual report.

Listen in on earnings reports – not necessarily for whether they beat Wall Street’s estimates or not, but for whether the story is true to your investment thesis still and what the future outlook looks like.

Have a Long-Term Outlook

Because volatility can be high with a concentrated portfolio, you need to have a long-term outlook to do well.

Sleep and Zakaria wrote to shareholders in 2006 that Nomad’s average holding period was seven years. Other investors holding the same stocks held for an average of only 51 days.

Day to day price movements are largely noise. Keep your eye on the prize and hold good assets for a long time.

Get Comfortable With Volatility

Concentrated portfolios are more volatile than diversified ones. That’s something you’ll have to get comfortable with if you want to stay the course.

It shouldn’t surprise you to see your investments fluctuate 10-20% on any week. During sharp market corrections or black swan events like in March 2020, realize your holdings might drop 50% or more.

Be honest with yourself if you can truly stomach these kinds of swings in your investment journey.

Takeaways

The message that everyone needs to have a diversified portfolio has been repeated so frequently over the years that we assume it’s a given. Hopefully this article has convinced you otherwise.

That said, having a concentrated investment strategy is not for everyone, either. If you don’t have the temperament for volatility or simply don’t have the time to manage your investments closely, a diversified portfolio is probably the right investment strategy for you.

If you’re looking to outperform the market, though, there’s no better way than to have a concentrated portfolio.

A few intensely researched ideas, a bit of time, and some concentration can be all it takes to build massive wealth.

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