Investing in high-quality UK shares for the long run is a proven strategy for building wealth. And many individuals have reached millionaire or even billionaire status, thanks to a successful investment portfolio. Of course, investing is not a risk-free endeavour. And, arguably, one of the most common pieces of advice to novice investors is to diversify their holdings.
However, not everyone is a proponent of diversification and instead stays in favour of maintaining a concentrated portfolio. The list includes some world-leading billionaire investors, such as Chamath Palihapitiya and even Warren Buffett.
So why is diversification potentially bad? And is a concentrated portfolio actually better?
Diversification vs Concentration
Diversification is a powerful risk-reducing strategy in an investor’s toolkit. But when misused, it can actually harm returns. Similarly, portfolio concentration paves the way for superior gains, but blindly hoping that a handful of stocks will perform brilliantly can be exceptionally risky.
For example, let’s say an investor has £10,000. After looking at several UK shares, they decide to invest in just one – Company X. A year later, their investment thesis succeeds, with the share price surging 50% and the investor enjoying a £5,000 return on investment.
But what if they had decided to spread their £10,000 equally across 25 different stocks, including Company X? In that case, the 50% gain would only boost the portfolio value by a measly £200. That’s a 2% gain instead of 50%. In other words, diversification reduces the positive impact of a successful investment within a portfolio.
However, this also works both ways. What if the investor was wrong and the Company X share price dropped by 40%? In that case, the losses in the diversified portfolio would stand at only £160 versus £4,000 in the concentrated.
So what is the right approach? The answer ultimately depends on an individual’s risk tolerance and stock-picking skill. Buffett’s argument against diversification is that it “makes very little sense for anyone that knows what they’re doing”.
His point is that a talented investor with an eye for finding high-quality enterprises shouldn’t start looking for other positions for the sole sake of diversification. Palihapitiya has similar views that it’s better to own 10 fantastic companies instead of 25 average ones.
Making £1m with top-notch UK shares
Arguably, the easiest way for novice investors to start building wealth in the stock market is a low-cost index fund. Here in the UK, the FTSE 100 is often a popular destination and has historically delivered an average annual return of around 8%. Investing just £500 a month at this rate for 30 years would lead to a portfolio worth roughly £745,000 when starting from scratch.
That’s certainly nothing to scoff at. But what if an investor instead chose to buy just a handful of top-notch UK shares that lead to an average 14% annual return? Over the same period, their portfolio would be worth a whopping £2.75m, reaching its first million within 23 years.
Needless to say, a hand-picked collection of high-quality businesses has the potential to deliver drastically superior returns. But it’s important to remember this is far from guaranteed. And with fewer stocks in a concentrated portfolio to absorb losses, any mistake can be far more costly.
