Concentrated Portfolio OR Diversified Portfolio?

There are arguments in favour of both concentrated portfolios and diversified portfolios in terms of risks and rewards. Therefore, DSIJ conducted a study spread over both bullish and bearish phases to find out if one is indeed better than the other.



In the world of investing you might have come across various quotes from seasoned investors such as: “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. You should actually diversify your investments to reduce the risk. This is the only free lunch available in finance where the risk reduces without impacting the potential returns. Another quote is: “Diversification may preserve wealth, but concentration builds wealth.” This is a famous quote from Warren Buffett. The question is how can you link these quotes to portfolio styles?

The first one supports a diversified portfolio style and the second one supports a concentrated portfolio style. When you invest in mutual funds, you are essentially buying a portfolio of stocks or bonds rather than individual securities. Therefore, it is not just the experience of the fund manager or his style of investing that matters but even the portfolio style adopted by the fund. There are two types of portfolio styles – concentrated portfolio and diversified portfolio. In the following paragraphs we will try to understand them individually.

Diversified Portfolio

A diversified portfolio is a portfolio wherein the assets or securities are such that they have minimum to no correlation with each other. This way it helps an investor with a diversified portfolio 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. Going by this ideology, even during a market crash a diversified portfolio will fall less as compared to a concentrated one. This we shall find out when we do our analysis to find out which portfolio style is better for you.

Concentrated Portfolio

A concentrated portfolio is the one that has only a few securities with very limited diversification. Typically, it has 20-30 securities or even less than that. Though a concentrated portfolio increases the risk, it also comes with 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. That said, more concentration leads to less diversification and hence returns of the securities are more correlated. 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.

Benefits of Diversification

There are some clear-cut advantages in favour of diversification, such as:

✓Shock Protection : A well-diversified portfolio can better absorb the shocks during a market downturn as the risk is well spread out when you invest in different asset classes having minimum or low correlation. Simply put, with a well-diversified portfolio, you can contain the losses in a better manner.

✓Weathering Market Cycles : As we all know, the economy moves through a cycle. During a cycle, markets move up, become stagnant, come down and go up again. With portfolio diversification, you can better weather market cycles and gain from the bullish runs. Also, when markets crash, diversified portfolios fall less compared to concentrated portfolios.

✓ Leveraging Growth Opportunities : It is possible to leverage growth opportunities made available in different sectors on account of investments made in different assets. Say for instance, of late gold has given spectacular returns and those having an exposure to the yellow metal have made significant gains.

Benefits of Concentration

There are some clear-cut advantages in favour of concentration too, such as:

✓Better Research: When you are dedicating a meaningful sum of money to a single share, better research is expected. A focused study is possible as the number of stocks involved is way less than that of a diversified portfolio.

✓ Focus on Performance of Each Share: When you have a smaller number of securities to look after, you know exactly what each one of them is doing. You have your eye on what your average cost is, at what price it is presently trading and where it is likely move. It is easier to decide whether to hold, accumulate or sell a particular security.

✓Better Returns: If proper research is done, its results are likely to yield better returns. In a highly diversified portfolio, even if you had your share of winners, the returns would get diluted with that of your losing stocks in the portfolio.

The Study

In order to find out which strategy works better, we have carried out an analysis of funds following a diversified approach and funds with concentrated portfolios. While doing so we have considered funds with 30 or less stocks to make for concentrated portfolios. To find a winner among them, we would compare its performance during the bull and bear phase. Also, in this study we have ignored sectoral funds, thematic funds, index funds and equity-linked saving schemes (ELSS). The period considered for the study is 2008 (bear) to 2009 (bull) and January 2020 – March 2020 (bear) to April 2020 – November 2020 (bull).



As seen, the results are quite confusing. Being a concentrated portfolio it was expected that it carried a lot of risk and the rewards would be better compared to a diversified portfolio. However, our study shows that things are quite different. In a bear phase, on an average, concentrated equity mutual funds fall less than diversified equity mutual funds. But during a bull phase, diversified equity mutual funds performed way better than concentrated equity mutual funds. Going one step further, we carried out an analysis of funds based on major equity categories i.e. large-cap, mid-cap and small-cap. Based on the number of stocks held by funds, we divided them into two categories i.e. diversified (holding stocks more than the median number of stocks) and concentrated (holding stocks less than the median number of stocks). We studied their performance during different phases of the market. Contrary to our expectation, there was no clear-cut relationship between the number of stocks and returns.

Conclusion

Our study shows that there is no correlation between the number of holdings and performance difference of a concentrated portfolio or diversified portfolio. This makes it even more confusing as to which portfolio style is better. That said, everything tones down to the quality of the fund. If the fund is of great quality and carries a concentrated portfolio style, it will follow the traits of a concentrated portfolio. Also, a quality diversified fund would follow the traits of a diversified portfolio style. And those funds that don’t fare on quality parameters would anyhow not perform, irrespective of being concentrated or diversified. Therefore, we still believe that a concentrated portfolio carries a lot more risk compared to a diversified portfolio. As such, investors having 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 holdings.