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Which one do you prefer: Concentrated or diversified portfolio?

Siddhi Sharma
/ Categories: Knowledge, MF
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Which one do you prefer: Concentrated or diversified portfolio?

In the world of investing, diversification seems to be the only free lunch. While diversifying your portfolio, your return potential does not reduce; however, your risks get mitigated. This is the reason why you hear from seasoned investors that, “Never put all your eggs in one basket.” This essentially means that you should not really depend on any single stock or investment or asset class in order to achieve your financial goal. You should actually diversify your investments to reduce the risk.   

Nevertheless, there is another quote that is diametrically opposite to this, “Diversification may preserve wealth, but concentration builds wealth.” This is a famous quote from Warren Buffett.   

The first one supports a diversified portfolio style while the second one supports a concentrated portfolio style.  

Diversified portfolio  

A diversified portfolio is a portfolio wherein the assets or securities are such that they have a very low correlation with each other. This way it helps an investor to reduce his overall portfolio risk. This is because no matter in which cycle the economy is, a few of your asset classes or securities will definitely perform while others may or may not. This portfolio style reduces risk considerably as it is rare that the entire portfolio would be hampered due to any ‘black swan’ event.   

Concentrated portfolio  

A concentrated portfolio is one that has only a few securities with very limited diversification. Typically, it has 20-25 securities or even less than that. Though a concentrated portfolio increases the risk, it also comes with a higher reward. Even Warren Buffett advocates this idea and says that “an investor should act as though he had a lifetime decision card with 20 punches on it.” This means that with every investment that he makes, his card will get punched, and he will be left with fewer cards for the rest of his life. Having said that, more concentration leads to less diversification. When it comes to a concentrated portfolio, the risk of suffering losses may occur as investors have a large portion of their holdings in one particular asset class, market segment, or security with respect to their overall portfolio.  

In order to find out which strategy works better, we have carried out an analysis of funds following a diversified approach & funds with concentrated portfolios. While doing so, we have considered funds with 30 or fewer stocks as concentrated portfolios and funds with more than 30 stocks as a diversified portfolio.   

 

   

Avg. return (per cent) 

1 year  

Avg. return (per cent) 

2 yrs  

Avg. return (per cent)  

3 yrs  

Avg. return (per cent)  

5 yrs  

Avg. return (per cent) 

10 yrs  

Focused Fund Returns  

53.41  

26.97  

14.99  

14.12  

13.20  

Diversified Fund Returns  

61.96  

28.37  

14.60  

14.20  

13.94  

 

As seen, the results are quite confusing. Being a concentrated portfolio, it was expected that it carried a lot of risks and the rewards would be better compared to a diversified portfolio. However, our study shows that there is no meaningful difference in the returns of both types of portfolios.   

There is no correlation between the number of holdings and the performance difference of a concentrated portfolio or diversified portfolio. Investors having a lower risk appetite should avoid investing in a concentrated portfolio and consider investing in a diversified portfolio while selecting funds based on their quality of holding. 

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