Overview – Portfolio Diversification or Concentration? The Never-Ending Debate
If you’re new to investing, it’s only a matter of time before you come across one of its oldest debates: portfolio diversification vs. concentration.
Some individuals champion diversification as a no-brainer when crafting a portfolio, whereas others argue that superior returns are only possible when a portfolio is concentrated. Naturally, this leads to the question of “which approach is best?”
Unsurprisingly, there is no consensus on which approach is better, with both offering unique strengths and drawbacks.
The purpose of this article is not to convince you to choose one approach over the other: to do so would be of little help to you since too much focus would be placed on the merits of one stance, then proceed to completely disregard the merits of the other (or worse, overemphasize the demerits).
Rather, in this article, we will discuss the major ideas and features of both a diversified and concentrated portfolio.
Diving Into Portfolio Diversification
Diversification is the practice of holding a wide variety of asset classes in your portfolio with the goal of reducing its overall volatility – that is, to minimize large swings in your portfolio’s market value by holding a diverse basket of different assets.
An example of a diversified portfolio is one that’s comprised of equities (i.e., stocks), fixed-income investments (bonds, GICs), real estate, precious metals (e.g., gold), and cryptocurrencies.
Diversification can become even more granular by diversifying specific components of an asset class.
For example, an investor may choose to diversify their stock holdings by allocating a specific percentage of holdings to certain industries (e.g. 30% technology, 30% financial services, 30% manufacturing, 10% oil & gas).
By having a diversified portfolio, the aim is to reduce the risk of loss by not being overly dependent on one asset class’ performance. Should one asset class underperform, the hope is that other asset classes will compensate for this loss by performing strongly, thereby resulting in a net gain for your portfolio, or at least performing strong enough to cancel out the losses.
If your portfolio is dominated by just a handful of very large holdings, if they experience a large loss in value then your portfolio will take a very heavy hit. This is a risk inherent to concentrated portfolios, so diversification tries to avoid that from happening.
One popular way to think of diversification is “Don’t put all of your eggs in one basket”. If you lose some eggs, no problem, you still have eggs being kept elsewhere.
Some financial advisors argue that not only is diversification important, but the percentages of which asset classes should be held depend on an investor’s age and risk tolerance.
Generally speaking, young people (individuals in their 20s and 30s, but this age range is by no means indisputable) are encouraged to have portfolios comprised mostly of equities and hold a relatively small amount of fixed-income investments.
Conversely, individuals who are retired or are close to retirement should, generally speaking, have a portfolio comprised mostly of fixed income while being light on equities.
By changing your portfolio diversification strategy as you age, the hope is that your investment needs are still being met while minimizing the risk of experiencing a very big loss.
One of the arguments made against diversification is that holding different asset classes in your portfolio makes little to no sense if you know what you are doing and that diversifying is simply protection against ignorance (more on this later).
However, there is a counter-argument against this belief, saying that diversification makes sense, especially if you know what you are doing.
Offshore tax and investment consultant Andrew Henderson argues that diversification is a sensible move because it serves as protection against sudden shocks and changes in the wider economy.
Every investor is susceptible to shocks in the global economy (no doubt almost every investor was affected in one way or another by the COVID-19 market mayhem), no matter how robust an investor’s portfolio or a given economy is, hence Andrew Henderson’s argument to diversify not just across different asset classes but across different countries as well.
So, if portfolio diversification sounds so great, what are the pros of having a concentrated portfolio?
The Case for a Concentrated Portfolio
While diversification is championed as one of the keys to achieving and maintaining a healthy portfolio, not every investor shares the same sentiment.
A couple of high-profile examples of investors who champion a concentrated portfolio are prominent investors Warren Buffett and George Soros, both of whom do not support the idea of diversification as a tenet of successful investing.
The argument for a concentrated portfolio put forth by Warren Buffett is that diversification is protection against ignorance and that it does not make any sense to diversify if you know what you are doing.
Mr. Buffett is most likely alluding to speculators who have not fully analyzed a prospective investment operation, and are therefore compensating for their lack of understanding of a particular enterprise by holding different asset classes with a higher chance of making gains.
Remember the definition of investing that was introduced in a previous article, which was defined as an operation that has, after thoroughly being analyzed, offers safety of principal and a sufficient return on that principal.
It can be argued that diversification is something speculators are more likely to champion because they know that they have not fully understood the investments they are buying (due to inadequately thorough analysis), hence the need to buy other asset classes to try and compensate for this lack of knowledge.
Therefore, the corollary can be made that an investor is better off dedicating their time to fully understand all the risks surrounding a business and hold only a few, carefully selected assets instead of spending that time looking for other (potentially speculative) asset classes.
This is why Warren Buffett makes so few investing moves because he spends so much time knowing as much as he possibly can about prospective companies before committing any capital (why else would he spend 80% of his day just reading?).
To him, diversification does not make much sense because he already knows so much about a company and its industry that if there was any risk of it substantially losing value, he would not put money into that venture in the first place.
This is why Apple makes up almost half of Berkshire Hathaway’s portfolio, and why he has continued to increase his stake in Bank of America.
American investment consultant and former Harvard Business School & Yale School of Management professor, Charles D. Ellis, makes the case for a concentrated portfolio by arguing that spreading your investments too thin may cause investors to not know enough about every holding, and can lead to an investor to act too slowly when making decisions, which can subsequently lead to investors not spending enough time researching and understanding individual companies as thoroughly as they’d like.
This builds into another argument for having a concentrated portfolio which states that although a diversified portfolio reduces volatility, diversification also reduces the likelihood that a handful of companies may prove to be superstars and exhibit exceptional performance.
Put another way, the argument is that diversification leads to a portfolio comprised primarily of mediocre holdings, instead of a portfolio comprised of a few, outstanding holdings.
One outstanding investment will contribute more to a portfolio than 100 mediocre ones – portfolio concentration’s focus is to find those few, outstanding investment opportunities, then to commit large amounts of capital to get the highest returns possible.
Now that we have an understanding of diversification and concentration, how do these compositions perform in the real world?
Looking at Different Portfolio Compositions
Now that we have a better understanding of portfolio diversification and concentration, it’s time to look at how these different approaches work in practice.
Below are different portfolio compositions from Fidelity Investments and RBC Global Asset Management.
The reason these portfolio compositions are from two sources is that they vary slightly in the assets they hold, but the expected outcomes are the same (in terms of return based on portfolio type – conservative, balanced, growth, aggressive growth).
When talking about portfolio compositions, “conservative” and “growth” represent two ends of a spectrum.
A conservative portfolio is one that likes to play it safe, so it’s comprised mostly of fixed-income/short-term investments. On the other hand, an aggressive portfolio focuses heavily on getting the best returns possible, so they’re comprised mostly of equities.
Have a look at the different compositions below. In the upcoming sections, we’ll discuss each portfolio composition. To make the discussion later go smoother, each figure below has been numbered from 1 – 5.
Figure 1 Discussion
When looking at the four portfolio compositions from Figure 1, each portfolio performed more or less how we’d expect them to theoretically perform.
On the basis of average annual returns, the conservative portfolio had the worst performance, the aggressive growth portfolio had the strongest performance, while the balanced and growth portfolios performed somewhere in between.
While the differences between the best 12-month returns and worst 12-months returns vary significantly on opposite ends of the spectrum, things start to get interesting when we look at the 20-year annualized returns.
When looking at the best 20-year annualized returns, the difference between the aggressive growth and conservative portfolios is only 5.51%. You’d expect that the gap would be a lot wider as the aggressive growth portfolio continues to grow rapidly, especially over the long run, but that isn’t the case.
This very narrow difference is also observed in the worst 20-year annualized returns, with a difference between the two extremes of only 0.26%. Even at its worst, the conservative portfolio only marginally beats the aggressive growth portfolio.
Figures 2 – 5 Discussion
When studying figures 2 – 5, we can again make similar observations.
Although the long-term time horizon in these figures is only 10 years, we again see that the difference in annualized returns is very slim. The difference in 10-year annualized returns between the conservative and aggressive growth compositions is only 0.8%.
Despite having different asset allocations and being measured over a shorter time, the observation made in Figures 2 – 5 is very similar to the one made in Figure 1, that is, over a long enough time the difference in annualized returns isn’t very extreme.
Key Takeaways From These Figures
When looking at all of the figures, there are a few key takeaways that we can extract.
As expected, the more aggressive a portfolio’s composition is the more susceptible it is to volatility. When looking at the aggressive growth portfolios from Figures 1 and 5, not only do they experience the highest returns over a 12-month basis, but they experience the steepest losses over a 12-month period as well.
As a portfolio starts to become more diversified (i.e., balanced), the effects of volatility start to become less extreme. This observation is consistent with the theory behind having a diversified portfolio that was talked about earlier – the more diversified a portfolio is, the less dramatic the swings are in its value.
The more concentrated your portfolio is in equities, the higher your potential returns are: this is clearly observed in Figure 1 and can also be observed in Figures 2 – 5 as the portfolios gradually increase their equity holdings.
This observation is consistent with the argument behind having a concentrated portfolio – limiting your holdings to a few, high-quality investments can potentially lead to some very significant portfolio growth. However, if things go sideways, prepare to take a very heavy hit to your portfolio’s value.
As we look at the data, it’s important to remember that one approach isn’t automatically superior to the other.
If you don’t want to deal with the emotional roller coaster that comes with volatility and you plan to invest for many decades to come, then a diversified portfolio may make sense for you.
If you’re very confident in your analytical skills, can effectively manage investment risk, have a keen eye for detecting very promising investments, and have a proven track record to back all that up, then perhaps having a concentrated portfolio will help you best reach your investment goals.
Wrapping Up
Despite the endless debate, no consensus exists on whether portfolio diversification or concentration is the optimal way to go.
Both diversified and concentrated portfolios offer their fair share of strong and weak points, and whether an investor adopts a certain stance depends on what exactly they want to achieve.
It is therefore important for investors to know exactly what their investing goals are, how confident they are in their analytical abilities, and how emotionally disciplined they are to properly determine how to arrange their portfolios.
There is no “perfect portfolio”, only a portfolio that suits the needs of a given investor at a given point in their life.
