This article was first published in the Hindu Businessline, Investment World, December 30, 2013; Co-Author: Lokesh Kumar, ISB.
One of the most famous proverbs in the financial world is, “Don’t put all your eggs in one basket”. The idea behind diversification is risk reduction by investing in a variety of assets.
Conventional theory also says that risk and return are proportional to each other. Diversification results in the reduction of risk, but returns also reduce.
John Maynard Keynes, the father of modern macroeconomics, held quite different views. Keynes believed that investing in a few stocks gives much better returns than diversification and his faith in portfolio concentration rewarded him far with superior returns than a widely diversified market portfolio. In his view, an investor who knows something about the market can get better returns by holding few stocks rather than a variety of assets.
Keynes also argued that a concentrated portfolio would be less risky than a diversified portfolio because the investor could undertake due diligence of stocks if his portfolio is limited and would typically invest within his circle of competence.
“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence,” said Keynes.
In a way, Keynes was emulating the idea of specialisation propagated by Adam Smith — the father of economics — who believed that breaking down a large job into many small jobs makes each employee an expert in one isolated area of production and thus improves productivity, which leads to higher economic growth.
Expansion of a portfolio beyond a certain number of stocks dampens performance because one loses the ability to effectively monitor the holdings. Keynes once said, “To carry one’s eggs in a great number of baskets, without having time or opportunity to discover how many have holes in the bottom, is the surest way of increasing risk and loss.”
In a research paper by Professors Zoran Ivkovi´c, Clemens Sialm and Scott Weisbenner, Portfolio Concentration and the Performance of Individual Investors published in the Journal of Financial and Quantitative Analysis in 2008, the authors show that investments made by households with concentrated portfolios outperformed those with diversified portfolios. The results indicate that households with concentrated portfolios evolve the ability to identify stocks that give higher returns.
A few other advantages of a concentrated portfolio are lower transaction costs and potentially lower monitoring costs. In comparison to a diversified portfolio holder, the concentrated portfolio holder has the fear of loss and that fear influences him to rigorously scrutinise companies before picking a stock.
For people who do not have risk appetite, or do not understand the business of the company in which they are investing, it is best to diversify.
Most fund managers invest in diversified portfolios as their customers may not have the ability to take a large loss. But those who have the risk-taking ability and appetite, besides the expertise to identify good stocks, might want to try their hands at concentration!