Last Updated on February 10, 2025
Overview – Portfolio Diversification or Concentration? The Never-Ending Debate
One of the oldest and, arguably, fiercely debated topics in investing is portfolio diversification vs. concentration. Knowing which approach to take is a decision all investors will eventually have to make.
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, as both offer 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 and then 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, generally speaking, is the practice of holding a variety of investments in your portfolio to reduce its overall volatility – that is, to minimize large swings in your portfolio’s market value.
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 currencies.
Diversification can become even more granular by diversifying specific components of an asset class. To go even further, investors may choose to diversify their portfolios by owning investments from various countries.
For example, an investor may choose to diversify their equity holdings by allocating a specific percentage of holdings to certain industries (e.g. 30% technology, 30% financial services, 30% manufacturing, 10% oil & gas). Investors can tweak their equity holding distribution based on a specific country/region of the world they have investments in.
By having a diversified portfolio, the aim is to reduce the risk of loss by not being overly dependent on one investment’s performance. Should a given investment underperform, the hope is that others 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.
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. In other words, diversification is unnecessary if you perform your due diligence extremely thoroughly.
While it is true that risk can be reduced by performing in-depth analysis and avoiding risky investments right from the start, the reality is that investors can’t control all the variables that affect their portfolios.
Every investor is susceptible to shocks from all kinds of sources, whether it’s geopolitical tensions, adverse economic developments, or unexpected government policies. Additionally, no investor has clairvoyance, and can’t say with full confidence what will happen to their portfolios several years into the future. These are variables that are well beyond an investor’s control yet can still affect their portfolios, regardless of how thoroughly they analyze which investments to acquire.
Therefore, a counterargument goes that diversification makes sense, especially if you know what you are doing.
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.
Some investors opt to maintain a portfolio comprised of only a handful of select investments. By doing so, they aim to achieve the highest returns possible by owning only a few exceptional investments instead of owning countless “mediocre” ones.
Similar to how diversification can be applied in a broad sense, so too can the same be done with concentration.
For example, one investor may choose to concentrate their portfolio by primarily holding equities in their portfolio and nothing else. Another may choose to invest in a handful of select industries while picking up whatever “hot” investments in those industries they can find. Another investor’s idea of concentration may be to focus on just one country.
Although the underlying idea behind concentration is relatively basic, its applications are seemingly endless, yet the underlying idea of finding a handful of exceptional investments remains unchanged.
That said, one question that may immediately come to mind is, “What’s considered a ‘concentrated’ portfolio?” Is there some kind of magic number or threshold that separates a concentrated portfolio from a diversified one?
Unfortunately, there is no such explicit distinction. What investors consider to be a “diversified” or “concentrated” portfolio will depend on multiple factors such as their individual preferences, risk tolerance, experience, and investment goals, to name a few.
For some investors, a portfolio comprised of 50 different equity investments may seem overly diversified, while others may view this as relatively concentrated. It all depends on the individual investor.
One of the most common reasons against having a concentrated portfolio is that it increases the investment risk you must shoulder, and that is, for the most part, a valid criticism. As we discussed earlier, there are a lot of variables that are beyond an investor’s control that can adversely affect their portfolios, regardless of what investments are in them.
However, that doesn’t mean investors are completely powerless. Investors are the ones who ultimately decide which investments they pursue, and they are the ones responsible for assessing the investment risk of each holding.
By maintaining a concentrated portfolio, not only will investors be more selective with the investments they acquire, but will also make it easier to perform on-going risk management. Keeping track of and having an in-depth understanding of a handful of investments (whatever a “handful” may look like for a given investor) is much easier than trying to keep track of dozens.
Is It Possible to Combine Elements of Both? Absolutely
Having explored the fundamental ideas behind portfolio diversification and concentration, it may seem like there’s no room for compromise between the two. If you go one route, you completely forego the other, right? Not necessarily.
This may sound counterintuitive, but it’s possible to implement elements of diversification and concentration simultaneously. Before looking at some examples, let’s first understand why.
An investor’s portfolio is incredibly multifaceted in terms of the countries they invest in, the different asset classes they can hold, and the types of industries/sectors they wish to pursue, to name a few elements. Because of this, just because one aspect of an investor’s portfolio is diversified/concentrated doesn’t mean all of them have to be.
For example, an investor can choose to invest in only one country, yet have a portfolio comprised of equities, fixed-income securities, ETFs, and mutual funds across a wide variety of different industries. Similarly, an investor may have investments spread across several countries, but all of those investments are in equities.
Theoretically speaking, there’s no limit on how investors can combine portfolio diversification and concentration: the only limit they have is their imagination.
If investors want to be completely diversified or concentrated in their investment activities, that’s fine. However, it’s important to remember that investors don’t need to go all-in with one approach and that both can be pursued simultaneously if they feel it’s best to do so.
Which Approach Produces Better Returns?
After having explored what portfolio diversification and concentration entail, we arrive at the big question that most investors will probably want to know: which approach will lead to better returns?
Before continuing, it’s important to remember that diversification and concentration seek to achieve different objectives.
A diversified portfolio attempts to minimize wide fluctuations in portfolio value and insulate a portfolio from steep losses in case some investments perform poorly. Concentrated portfolios try to contain a handful of “strong” investments to get the highest returns possible but at the risk of suffering potentially steeper losses. Pursuing both attempts to create a “best of both worlds” scenario with varying degrees of success.
Let’s not forget that there are a multitude of factors, both controllable and uncontrollable, that affect portfolio performance too, and sometimes unexpected developments can greatly elevate or decimate a portfolio.
With all of this in mind, we can now arrive at our answer: both approaches (or a combination of them) have a roughly equal chance of producing adequate returns.
A diversified portfolio comprised of “mediocre” investments that are well insulated against geopolitical, political, and economic risks has the potential to perform just as well as a portfolio comprised of “superstars” but are constantly subject to the whims of external factors. The opposite can also happen: a concentrated portfolio comprised of a handful of investments can potentially match the performance of an extremely diversified portfolio spread across several countries and asset classes.
Both approaches are equally valid, and assuming the investor managing the portfolio knows what they’re doing, have the potential to post equally satisfactory returns.
Wrapping Up
When it comes to how investors choose to construct their portfolios, there are two approaches that are commonly touted: diversification or concentration.
A diversified portfolio seeks to provide steady returns while minimizing the effects of volatility or the risks posed by individual holdings. Concentrated portfolios, on the other hand, try to achieve the highest returns possible by holding a handful of “exceptional” investments, at the cost of potentially being subject to the effects of volatility or investment risk.
Although these two approaches are distinct, that doesn’t mean they must be pursued in isolation. It’s possible to pursue both approaches simultaneously to varying degrees – the only limit in how to do so is an investor’s imagination.
Both approaches seek to achieve different objectives, so one isn’t necessarily “superior” to the other. In the hands of a skilled, knowledgeable investor, both approaches (or some combination of the two) are capable of producing adequate investment returns.
