Concentration vs diversification: I’m with Warren Buffett

A question all investors face is how many stocks to own. Stock market superstar Warren Buffett thinks we should be selective, as long as we know what we’re doing.

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A question that all investors inevitably face is how many stocks they should own. Stock market superstar Warren Buffett thinks we should be selective, as long as we know what we’re doing. Today, I’m looking at the advantages (and disadvantages) of following this advice. 

Why is Warren Buffett such a fan?

Buffett compared owning lots of stocks to owning a zoo. This approach may protect my capital but it won’t necessarily grow it. 

A quick bit of maths bears this out. Let’s say I own 50 stocks. If one of these doubled, it would increase my overall portfolio value by 2%. However, the effect of a single stock doubling naturally has a greater impact using a concentrated strategy. In the same scenario, the overall portfolio value would rise 10% if I owned just 10 stocks.

Clearly, if I were able to repeat this performance over many years, my wealth would multiply far quicker!

In good company

It’s easy to dismiss Buffett’s take on the concentration/diversification debate. Praising the former when you’re already extraordinarily wealthy makes sense. However, he isn’t alone in believing that the best returns come from this strategy.

In his book ‘100 baggers‘, author Christopher Mayer highlights how many of the world’s most successful investors, such as Bill Ackman and Bruce Berkowitz, have only a few holdings. At the time of writing, these people had the equivalent of billions of pounds invested in only their best seven and eight ideas respectively. 

As far as the UK’s concerned, top fund managers like Terry Smith have long praised the concentrated approach. And the performance of Fundsmith Equity speaks for itself! 

So, am I 100% with Buffett?

I don’t agree with Buffett completely. I don’t have money to burn. Nor do I have the same level of experience in the markets as the 90-year-old all-time investing great. To be clear, there are certainly issues with me adopting this strategy.

Perhaps the most obvious is that I might own the wrong stocks. These could tumble on poor trading or even cease to exist! A stock that goes to zero reduces the value of a 10-stock portfolio by 10%. For a 50-stock portfolio, it’s a more palatable 2%. There’s also a psychological benefit of being diversified. A portfolio that keeps me awake at night just isn’t worth bothering with. 

On the flip side, owning a small number of stocks may give me an edge. Since more of my money is invested in them, I’m compelled to be up to date with developments and know why they’re worth holding.

This comes into its own when investing lower down the market spectrum. Many people simply don’t have the time or inclination to thoroughly research market minnows that could generate explosive returns in time. 

Bottom line

To his credit, Buffett thinks most people shouldn’t be concentrated investors. They should just invest in index funds and not try to beat the market. I’m inclined to agree, especially for those who have no interest in stocks.

For more active investors like me however, I think the message needs to be that there’s no ‘perfect’ number of stocks to own. Instead, my portfolio should reflect a sober evaluation of my tolerance for risk. Setting achievable goals is also vital.

Get this right and I could do well, albeit maybe never as well as the Sage of Omaha.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers owns shares in Fundsmith Equity. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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