Most basic articles on personal finance advise investing in a diversified portfolio. Diversifying investments is touted as reducing both risk and volatility. While a diversified portfolio may lower your overall risk level, it also reduces your potential capital gains. The more extensively diversified an investment portfolio, the more likely it is to mirror the performance of the overall market.
Since many investors aim to beat the market, they may wish to revisit the issue of diversification versus concentration in their portfolio choices.
While diversification is a good way to preserve wealth, concentration is often a better way to build a fortune.
How to Diversify a Portfolio
There are several ways to attain diversification. One way is to diversify your investments among several different companies. It is also possible to diversify among various sectors. Owning stock in both a technology firm and an energy company provides more diversification than simply owning two tech stocks.
More diversification can be achieved by investing in companies with varying market capitalizations. Returns are often different for small-cap stocks and large-cap stocks. Portfolio diversification can also be obtained by investing in foreign companies instead of just domestic firms. Pursuing different strategies, such as growth or value investing, also provides diversification.
The highest level of diversification can be achieved by investing in different asset classes. Bonds are far less volatile than stocks, and government bonds often go up in price when stocks go down. Commodities are another significant asset class with a different pattern of returns. Finally, buying and selling options on stocks, commodities, and other assets provides even more diversification.
The real question is to what extent investors should diversify their portfolios. The answer depends on personal goals, risk tolerance, and preferred investment strategies. Investors should consider the relative advantages and disadvantages of diversification within a personalized framework.
Advantages of a Diversified Portfolio
Diversification reduces an investor's overall level of volatility and potential risk. When investments in one area perform poorly, other investments in the portfolio can offset losses. That is particularly true when investors hold assets that are negatively correlated.
For example, long-term U.S. Treasuries made significant gains when stocks declined in 2008. Diversification may also open up additional profit opportunities.
An investor who chooses to diversify with investments in foreign stocks can try to put funds into countries experiencing economic booms. Those shares can produce substantial gains at a time when the performance of domestic stocks is mediocre to poor. Such a situation occurred in the U.S. between 2003 and 2007, when foreign stocks consistently outperformed U.S. markets.
Disadvantages of Increasing Diversification
The problems with diversification are less publicized, and therefore less well known. The truth is that diversification can also have adverse effects on an investment portfolio. Diversifying an investment portfolio tends to limit potential gains and produce average results. An investment portfolio of five carefully chosen stocks can substantially outperform the market. Watering it down with dozens of other stocks leads to mediocre performance.
Another problem with aiming for broad diversification is that it may require extra work to rebalance your portfolio. A widely diversified portfolio with a lot of different holdings is generally more trouble to monitor and adjust since the investor has to stay on top of many investments. Diversification can even increase risk if trying to diversify leads an investor to become careless. In many cases, investors seeking high levels of diversification are better off with mutual funds or exchange-traded funds (ETFs).
Advantages of Concentrated Portfolios
One of the benefits of a more concentrated portfolio is that while it does increase risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are not usually widely diversified. Those with investments concentrated in a few companies or industries are better at building vast wealth.
A more concentrated portfolio also enables investors to focus on a manageable number of high-quality investments. Wiliam J. O'Neil, Gerald Loeb, and Jesse Livermore built their fortunes through concentrated investments.
The Bottom Line
The best path for an investor may be to aim for only a modest amount of diversity while primarily focusing on selecting high-quality investments. These investments should be chosen using a preferred investment strategy, such as growth investing, income investing, or value investing. Personal risk tolerance and overall investment goals are also important.
While some level of diversification should be a consideration in constructing an investment portfolio, it should not be the driving concern. The primary focus of an investment portfolio should always be meeting the personal goals and financial needs of the individual investor.
FAQs
Every investor must decide how to structure their investment portfolio. Two primary strategies widely discussed are diversification and concentration. Diversification involves spreading investments across various assets. Concentration focuses on a limited number of assets or sectors.
How concentrated should your portfolio be? ›
Key Insights. Concentrated stock positions can increase the market risk in your portfolio. A concentrated position represents any holding worth at least 5% to 10% of your overall portfolio. Addressing a concentrated position requires planning to avoid tax implications and other issues.
Is it better to have a diversified portfolio? ›
Portfolio diversification involves investing in many different securities and types of assets so that your overall return doesn't depend too much on any single investment. Financial experts often recommend a diversified portfolio because it reduces risk without sacrificing much in the way of returns.
What are the benefits of concentrated stock portfolio? ›
Advantages of Concentrated Portfolios
One of the benefits of a more concentrated portfolio is that while it does increase risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are not usually widely diversified.
What is the difference between focused and diversified strategy? ›
While a niche focus offers depth and expertise in one area, diversification provides breadth and protection against market fluctuations. Each strategy has its merits and pitfalls, and the right choice depends on a nuanced understanding of both the business and the market it operates in.
Is concentration better than diversification? ›
As Warren Buffet put it, diversification may preserve wealth, but concentration builds it. The downside to concentration, of course, is that it increases the risk. If the asset you chose doesn't perform as expected, you could face losses.
What is the 3 portfolio rule? ›
A three-fund portfolio is an investment strategy that involves holding mutual funds or ETFs that invest in U.S. stocks, international stocks and bonds. The strategy is popular with followers of the late Vanguard founder John Bogle, who valued simplicity in investing and keeping investment costs low.
Does a diversified portfolio beat the S&P 500? ›
A diversified portfolio might outperform or underperform an index such as the S&P 500, which only measures U.S. large cap stocks, on any given day, quarter or year. But short-term returns are not a long-term investment plan.
What is an example of a concentrated portfolio? ›
So if you think about the S&P 500 has lots of different sectors, you could have a lot of stocks, but say you put them all in one or two sectors, you would, you would have a concentrated portfolio simply because it had made a directional, positioning versus a more diversified situation.
How many stocks are in a concentrated portfolio? ›
The conventional investment wisdom is that a diversified portfolio should hold 25 to 30 stocks. This is concentrated enough so that good stock selection will produce positive results and allow for outperforming the indexes but not so concentrated to produce risk that one bad stock will destroy investment returns.
These various assets work together to reduce an investor's risk of a permanent loss of capital and their portfolio's overall volatility. In exchange, the returns from a diversified portfolio tend to be lower than what an investor might earn if they were able to pick a single winning stock.
How to build a concentrated portfolio? ›
A concentrated portfolio refers to one that consists of only a few securities with limited diversification. Such a portfolio has 20-30 securities or even less. In terms of equity mutual funds, it refers to the schemes that hold a few stocks and higher exposure to individual stocks.
What are the risks of concentrated stock positions? ›
Risks: Boom or Bust
Owning too much of one company exposes the client to both company and market risk. If the company becomes insolvent or an industry shake-up or bear market occurs, the loss can be devastating for the client's portfolio.
What is the difference between concentrated buying and diversified buying? ›
What is the difference between concentrated and diversified portfolios? A concentrated portfolio is one where you put most of your money in one company or sector. In a diversified portfolio, you spread out the risks.
What are the disadvantages of focus strategy? ›
A focused strategy also entails some challenges to be aware of. One of the main risks is that the niche market may become saturated, shrink, or disappear due to changes in customer tastes, technology, or regulations.
Do diversified or focused firms make better acquisitions? ›
Diversified firms may create more value through acquisitions than focused firms if they have more experience creating operating synergy, more institutional learning from doing past acquisitions, or if they attract higher quality CEOs because they are larger and more complex firms offering higher compensation.
What is 80 20 rule in portfolio management? ›
The 80-20 rule can be applied to investing in different ways. One way is to allocate 80% of your portfolio to low-risk, diversified assets, such as index funds, and 20% to high-risk, high-reward assets, such as individual stocks or cryptocurrencies.
What percentages should my portfolio be? ›
A moderately aggressive strategy would contain 80% stocks to 20% cash and bonds. For moderate growth, keep 60% in stocks and 40% in cash and bonds. A good rule of thumb is to scale back the percentage of stocks in your portfolio and increase the percentage of high-quality bonds as you age.
What is the 60 40 portfolio rule? ›
The classic 60/40 allocation is very intuitive. The 60% equity allocation provides the lion's share of the returns as a simple yet effective exposure to broad economic growth. And no one wants too much risk, so the 40% bond allocation is a simple way to diversify the portfolio and avoid excessive risk.
What is the 70 30 portfolio strategy? ›
The strategy is based on:
Portfolio management with 70% hedge and 30% spot delivery. Option to leave the trade mandate to the portfolio manager. The portfolio trades include purchasing and selling although with limited trading activity.
