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Concentrated Portfolio: The 4 Hidden Risks for the Average Investor

Having a concentrated portfolio of stocks has been the secret to success for many great investors. There was even a book written on the topic called The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy, which highlighted exactly that.

Some of the best investors with concentrated portfolios highlighted in the book include:

  • John Maynard Keynes
  • Charles Munger
  • Warren Buffett
  • Bill Ruane
  • Lou Simpson

Trust me, I know all about the appeal of having a concentrated portfolio—one where you have one (or several) stocks that make up a large percentage of your overall portfolio.

But, there’s several risks to consider which I believe aren’t talked about much.

And though Buffett is one of my heroes, I’ve come to the conclusion that a concentrated portfolio is probably not the right solution for the average investor, and certainly not for most.

Let’s discuss the biggest risks of a concentrated portfolio, as broken out into these 4 sections:

  1. Arrogance Before the Fall
  2. Survivorship Bias
  3. Sitting On Your Hands
  4. Emotional Volatility

Whether you ultimately decide whether a concentrated portfolio is right or not is up to you; I’m not going to try and convince you one way or the other.

And in fact, just because I write this post doesn’t mean I might not have a concentrated portfolio in the future, especially if I pick several stocks that go into 10 (or 100) bagger status.

I just want us to recognize the risks, so we are cognizant of them and make good decisions, with this as a context to have in mind.

Risk #1 – Arrogance Before the Fall

Going back to the very beginning of this post, there’s no doubt that the greatest investors of all-time leaned on making big bets on their highest conviction picks.

Warren Buffett has had a lot to say about the topic—my favorite is the punch card technique.

Buffett says that it’s a great idea to approach picking stocks as if you had a punch card with only 20 spots, and each time you bought a stock you punched a hole in one spot.

If we really had this restriction on ourselves with our stock picking, you can be sure we’d be extremely careful about the stocks we buy. It’s a great idea because it leads to really spending a lot of time on researching the company and reinforces the idea of investing with a margin of safety.

If we were to use the punch card technique when buying stocks, we’d be sure that the stocks we purchased fell within our circle of competence.

And when Buffett finds a stock within his circle of competence, and it’s a “punch card” opportunity, he backs up the truck (puts a heavy part of his portfolio into it).

The problem is that we are not Buffett.

Compare Buffett with the average investor; Buffett spends probably 40+ hours a week reading and researching about companies, while the average investor might spend an hour or so a day.

I don’t say that to belittle the average investor’s efforts, we just need some good old-fashioned humility every once in a while.

When Buffett made one of his most concentrated bets, Coca Cola in the late 1980s which made up as much as 40% of his portfolio at the time, he had already been a full-time professional investor for over 3 decades.

Even when Buffett first started out in 1956, he was miles ahead of most average investors. They say that Buffett had read the entire investing section of the library at the age of 10, and bought his first stock at the age of 11!

The problem with a circle of competence (and I’m as guilty as anyone) is that you don’t know what you don’t know until you learn what you don’t know.

It’s really easy for us as average investors to look at Mr. Market’s seeming mispricings and assume we always know better—but sometimes the market is right and you are wrong. Sometimes you don’t truly understand a business and why it deserves to trade at a higher valuation than you think it should (and also with one that deserves its low valuation).

Again, I’m as guilty as anyone, which is why that humility is so important.

Which goes back to the discussion about having a concentrated portfolio, and why the average investor needs to be careful with it.

Having high conviction about a stock is one thing, and having a level of overconfidence (especially with little experience) enough to make a huge bet on that conviction can lead to a lot of future humble pie.

One of the best arguments for a diversified portfolio over a concentrated one is that it tempers the negative effects of overconfidence, by not allowing any one mistake (or error in analysis) take too much of a chunk out of your portfolio.

The less time you’ve dedicated to this game, the more you should follow this advice, in my opinion.

Risk #2 – Survivorship Bias

Let’s go back to the beginning of this post again. Remember that long list of successful investors? Do you recognize a commonality between them?

If you answered that they were all successful, then you’re exactly right.

And that’s the problem.

There’s some well known behavioral finance biases that plague lots of investors and research efforts, and a big one is survivorship bias.

When you’re looking for lessons from success (which I do all the time), you have to be cognizant of the fact that a study on success is not fully unbiased unless it looks at the winners and losers equally.

The problem with those who lose from a concentrated portfolio is that their stories don’t get much fanfare; nobody wants to read an uninspiring book about “unskilled” failures.

But for every great investor who used a concentrated portfolio to greatly outperform the market, I can guarantee you that there are a hoard of investors who used a similar portfolio strategy only to greatly underperform.

We don’t hear about it for all of those reasons, and so we need to be careful about assuming that a concentrated portfolio itself is a secret to success just because it worked for that list of investors.

Risk #3 – Sitting On Your Hands

Going back to Buffett and Munger for a moment, these billionaires recommend another investing strategy which I don’t believe is appropriate for the average investor.

There’s another great idea which I also love where Buffett says investors can wait for their perfect pitch.

It’s a reference to baseball, where hitters are thrown pitches and must swing or else they might strike out.

Since investing is not baseball, there’s no penalties for not “swinging”, nobody is forcing anyone to invest into the market at any given time.

The problem with this philosophy is that we aren’t all (financially free) billionaires like Buffett or Munger.

Andy Shuler wrote a fantastic post about the difference between short term and long term S&P 500 returns, and showed that if investors were to simply build a consistent habit of investing rather than sit on cash and wait for the best opportunities, they’d be better off in the long term.

I don’t want to imply that this is exactly what Buffett meant when he made the great fat pitch metaphor, but I see it taken out of context by investors all of the time, and it becomes an excuse to hold cash to try and time the market.

This ties into concentrated portfolios because it’s easy to say that investors should wait for a fat pitch and make a big bet when it appears, but the actual application of that can be very counterproductive.

If we can comprehend that we probably won’t be the best at market timing, and that we might not have as strong of a circle of competence as we like to think, then it would behoove us to act that way by diversifying our portfolio and dollar cost averaging.

Dollar cost averaging is simply building an investing habit and sticking to that habit.

If you truly are going to dollar cost average, and if you care about the price you pay with the stocks that you buy, it’s going to be extremely difficult to both build a concentrated portfolio and achieve both of those goals.

You could certainly sell multiple stocks and then consolidate them into a single position into the future, but in that case you are forcing your portfolio decisions on your stock decisions rather than the other way around.

I highly doubt that there are many times in investing where 3 or 4 stocks in your portfolio are suddenly too expensive or have had their fundamentals change so much that you should sell.

So, there won’t be many chances to sell multiple stocks, which makes it hard to build a concentrated portfolio unless you are stockpiling cash.

You could ease into a position by dollar cost averaging over many consecutive months, but if the stock runs away from you with a higher valuation you’ll lose that opportunity.

I saw all of this from experience, because I tried both of those things and did not like the resulting emotions after it was all said and done.

Bottom line—Buffett and Munger have the luxury to sit on their hands because they’ve already accumulated massive wealth and truly don’t need any more money.

The average investor is likely trying to build to a Buffett and Munger level of financial freedom, and so sitting on your hands just means losing precious time for compound interest to work its magic.

Risk #4 – Emotional Volatility

We’ll wrap up with the emotional side of a concentrated portfolio, which is so critical because it’s the toughest part of investing.

Again I say this with experience—it’s SO easy to say that you won’t get emotional when your stocks face volatility, but it can be gut wrenching.

It’s hard to really portray the disappointment of having an entire portfolio where stocks that used to be up 20%, 30% or 50% are now at breakeven or at a loss; it makes you feel like the time (years) you invested with the stock were worthless.

And then imagine doing that when the stock market is roaring, but your portfolio is down due to a bad concentrated bet.

Your chances of having that happen to you are greater with a concentrated portfolio, and it takes the ice cold veins of a mountain to resist feeling bad about that happening to you.

Investing is supposed to be a pleasant experience where you can sleep peacefully at night, and know your hard earned savings is being put to work and continues to grow over time.

When you get extreme volatility in your portfolio, which is almost always magnified in a concentrated one, that joy of investing gets robbed and can turn you off forever from the stock market.

That’s a particularly somber thought, because the biggest losers in the stock market are not those who underperform but those who quit forever and thus lose out on the best vehicle towards building financial freedom.

By building a more diversified portfolio, you can alleviate your future self from some unnecessary stress, and that’s worth it’s weight in gold particularly when times get tough.

Investor Takeaway

I know many investors get gung-ho about investing and picking stocks and really latch on to the concentrated portfolio idea.

I know because I did the exact same thing.

There’s probably many of you out there reading this right now who should proceed with a strategy like that anyway, but you should proceed well aware of the risks.

Building a concentrated portfolio should be an after-result of many hours of thinking and studying, even decades if you can.

As investors first starting out, it’s of critical importance to get your feet wet before you attempt to be an Olympic swimmer. A concentrated portfolio should be the end game strategy for an investor rather than a beginning one, and needs to receive the appropriate attention and care that its implications can bring.

Sorry to burst your bubble, but if you’re truly going to invest with a margin of safety, emphasis on the safety, portfolio construction is just as important as everything else.