I reckon it’s wise to diversify a shares portfolio between several stocks. Such an approach can help to minimise the damage if one company suffers a setback or failure. However, ultra-successful investor Warren Buffett once said: “Risk can be greatly reduced by concentrating on only a few holdings.”
Over-diversification can be problematic
And to me, that advice suggests it’s possible to take diversification too far. After all, if my portfolio contains as many as 50 stocks, the potential outperformance of a few of them could become diluted. And if that happens, my overall portfolio returns could remain lacklustre.
On top of that, I reckon it’s almost always difficult to find 50 stocks with decent growth prospects selling at fair valuations. And the danger is that I may relax my stock-picking standards just to make up the numbers for my portfolio.
But that’s not the only problem. The third challenge of a large portfolio is that it’s almost impossible for me to follow the news from so many companies. And the big risk is my buy, sell and hold decisions could end up being of poor quality.
Buffett is even more forthright in another of his quotes: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
The trouble is, I didn’t know much when I first started investing. But an elegant solution would have been to choose share funds and tracker funds in the beginning. Then, as experience and confidence grew, I could have introduced a few well-researched and high-conviction stocks. That idea sounds so good to me now that I wish I’d actually done it when starting out!
I’m following Warren Buffett’s advice now
However, my tortuous investing career has eventually ended up with me following Buffett’s advice to run a more concentrated portfolio. But these are my best ideas and my highest conviction shares. Of course, there’s no guarantee they’ll go on to perform well just because I’ve researched the opportunities and like them. All stocks carry an element of risk. And I could lose money. Indeed, the losses could be magnified because the stocks have a high weighting in my portfolio.
But with a low limit on the number of positions in a portfolio, what happens when another great stock opportunity arrives? Earlier in his career, Buffett was used to dealing with that problem. In Alice Schroeder’s authorised biography on Warren Buffett, The Snowball, she quotes him as saying: “If I was enthused about a stock I would have to sell something else to buy it.”
And in his book Beating the Street, ace fund manager and investor Peter Lynch said: “Most of my abrupt changes in direction were caused not by any shift in policy but by my having visited some new company that I liked better than the first… Â In order to raise the cash to buy something, I had to sell something else…”
If used sparingly, I reckon the tactic of selling one stock to buy something better could work to raise the quality of my portfolio. However, if used too often, I could slip into over-trading.