Should you invest in a concentrated or diversified portfolio?

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, 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 by Warren Buffett. The question is, how can you link these quotes to portfolio styles?  

The first one supports a diversified portfolio style while 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 relation or no correlation at all 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. We shall find out more about this while doing our analysis of checking the best portfolio for you.  

Concentrated portfolio 

A concentrated portfolio is 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 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, 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 concerning their overall portfolio. 

The study 

In order to find out which strategy works better; we have carried out an analysis of the funds following a diversified approach along with the funds with concentrated portfolios. While doing so, we have considered funds with 30 or fewer stocks to make for concentrated portfolios. To find a winner among them, we would compare its performance during the bull & 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 in the above table, 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 things are quite different. On average, in a bear phase, concentrated equity mutual funds fall less than diversified equity mutual funds. However, diversified equity mutual funds performed way better during a bull phase 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 expectations, 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 the performance difference of a concentrated portfolio or diversified portfolio. This makes it even more confusing as to which portfolio style is better. Nonetheless, everything tones down to the quality of the fund. If the fund is of greater 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 one. As such, investors having a lower risk appetite should avoid investing in a concentrated portfolio and consider investing in a diversified one while selecting funds based on their quality of holdings.