Should you have lots of eggs or try to pick a few good ones? Pic: Getty Images
Experts
When it comes to investing, diversification, or not putting all your eggs in one basket, is often seen as key to reducing risk. It means if one holding underperforms it will have a small impact on the overall portfolio.
But what about less is more? One of the world’s most famous investors, 92-year-old Warren Buffett, has throughout his long career put forward a strong case for concentration.
“You know, we think diversification is — as practiced generally — makes very little sense for anyone that knows what they’re doing… it is a protection against ignorance,” he said.
So, what is the case against diversification and for concentration? Is diversification really the best way to invest in the market?
Contrarian long-term fund manager Allan Gray Australian investment analyst Dr Justin Koonin believes greater diversification is often not the answer to gaining long-term outperformance.
Koonin told Stockhead while some diversification is undoubtedly helpful in reducing risk, being overly diversified can be detrimental to returns.
“When we say be somewhat concentrated, no one is saying put all your money in one stock,” he said.
“There are some benefits to diversification and if you invest solely in one stock it is quite risky, but the opposite extreme is that it’s unlikely that anyone has 100 good ideas.
“The more stocks you have the more you will end up looking like the overall index and your performance is likely to be mediocre.”
He said an index-tracking ETF will provide plenty of diversification, but the more you diversify the more you’re guaranteeing an average result.
“If you want to outperform then you need to invest differently.”
Koonin said if you want to maximise your expected outcomes in the long-term, then you have to take bigger bets in stocks.
“The reason people don’t do that is the more you concentrate your portfolio, the greater the volatility becomes,” he said.
Koonin said it is often taught that risk and volatility are the same, but this is not the case.
“We’re often taught that risk and volatility are the same thing and the more volatile your portfolio then the riskier it is,” he said.
“But we would question that. We believe risk is the potential for long-term permanent loss of capital,” he said.
Koonin said volatility, or whether an investment is going up or down during your investment, is often given too much consideration.
“If you are investing for the long-term, you just want to maximise where you get to at the end and a more concentrated approach is likely to be more volatile compared to an index or market portfolio,” he said.
“But we would say that is a necessary price to pay for long-term outperformance.”
Koonin said there are times short-term risk must be considered.
“If you were saving for a house deposit, you won’t want your portfolio to be down 20% in the short term because you need the money sooner,” he said.
“But if you’re investing with a longer timeframe, the real risk is impairment of your capital and so what we want to focus on is how do you get the best result in 5, 10 or even 20 years.”
Koonin said Allan Gray has tended to be more concentrated than the broader market and backs its biggest conviction ideas.
“Sometimes that works and sometimes that doesn’t work but if you’re right more than you’re wrong, and if your winners are bigger on average than your losers, in the long term hopefully it will work out in your favour.”
“We are transparent with our clients that we are not afraid to be different and not afraid to be wrong and that means people who invest with us know they might be getting some volatility.”
He said careful stock picking can also help mitigate the risk of permanent loss of capital in concentrated portfolios.
And outperformance over the long term does not solely depend on the stocks picked but also significantly depends on the weight of the stocks in the portfolio.
Allan Gray believes investors need to think about risk and pay attention to stock weightings in 2023.
“Hit rate – or the number of stocks in a portfolio that outperform – isn’t everything,” Koonin said.
“You can outperform with a low hit rate if the upside of the outperforming investment is large, and you can underperform with a high hit rate if you don’t allocate enough of your portfolio to those stocks.
“Getting the balance right is key.”
The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.
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