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Concentrate or diversify?

Wednesday, May 7, 2014

Sharing an email exchange here:

Hi AK,

I am a retail investor who has been investing for some time, and I've also been a long time reader of your blog. Before I go on any further, I would like to thank you for your blog as it has provided many people with valuable insights on investing and personal finance. Your contribution to the investment community is immense, I sincerely hope that you continue blogging!
I have a question regarding diversification vs concentration. While I am aware of the benefits of both strategy, I'd like to hear your view on this topic. Very often, I find myself identifying several undervalued companies. However, instead of buying all of them, I try to narrow it down to 1 or 2 high conviction stocks. As such, my portfolio tends to be extremely concentrated. I take into account factors such as the potential upside, catalyst, expected holding period, circle of competence etc.

While my investment record is satisfactory, I have missed many opportunities (mainly because it is impossible to predict when prices will rise) when I did not buy the other undervalued stocks.

Diversification will solve that problem. However, I might risk missing out on huge gains from my high conviction ideas just because I don't want to lose out on the others when prices rise. I hope to find an investment philosophy that would help me reconcile these two strategies and would love to hear your views on this. Thank you.

My reply:

Hi WJ,

From your email, I get the impression that you prefer a concentration strategy. You have, however, rightly pointed out one of the weaknesses of such a strategy, especially if our funds are limited.

There is a simple solution to the problem you have. Do a lesser form of concentration. What is this?

Let us say you had identified 10 stocks which met your criteria, instead of selecting 2 stocks to put all your money into, put 50% of your money into these 2 stocks. The other 8 stocks get the rest of your money.

You could argue that this is diversification but diversification to me is 10% of your money in each of the 10 stocks. OK, if you like, my suggestion is an adulterated form of diversification. A rose by any other name smells just as sweet. ;p

Best wishes,

Related posts:
1. Excuse me? Are you an investor?
2.  Luck plays a part in investing.
3. The Little Book That Beats The Market.
4. Approach to stock selection.
5. Value investing.


ozxinvest said...

If I were you:

If I were to start with a small capital, I will use concentration strategy. The pain of losing my capital is bearable and I can start all over again, taking with me what I should not have done or what I will do again.

The pain of not able to participate in other potential stocks is simply non existence as I understand I do not have the muscle to carry all the weights at one time.

If I have accumulated a much larger capital, I will start using diversification strategy as now I will have the muscles to carry more weights if not all of them, and the pain of losing my capital is now much more than before, and I'm more concern to protect it rather than losing it.

That is, if I were you, but i'm not.

E H said...

The question to WJ should be, which are the 2 high conviction stocks he picked?

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