Portfolio manager Andrew Padoa speaks about concentrating investments on a few top-quality companies, as advocated by investment greats like Lou Simpson, leads to better long-term returns compared to spreading investments thinly across many stocks.
“The appeal of a concentrated portfolio is that it is the only chance an investor has to beat the averages by a noteworthy margin.” Frank Martin
Lou Simpson is considered an investment legend. He joined GEICO (the insurance arm of Berkshire Hathaway) in 1979 and served as the companies Chief Investment Officer before retiring in 2010. He achieved remarkable investment returns, outperforming the S&P 500 by almost 7% per annum between 1980 and 2004. These outstanding investment returns created substantial wealth for GEICO as well as Berkshire Hathway.
One of his investment philosophies that resonates, was his focus on concentrated portfolios. He firmly believed that the more stocks you hold in your portfolio and the more you diversify, the more your performance is likely to be average. Simpson challenged the notion that diversification alone guarantees success, arguing that diluting investments across many stocks could limit the impact of high-performing assets on overall portfolio returns. He questioned the wisdom of investing in multiple mediocre ideas when focusing on a few exceptional opportunities could yield more significant results.
Simpson has a great point. Why invest in your 40th or 50th best idea? Imagine maintaining a portfolio with 50 stocks, each equally weighted. If one of these stocks’ doubles in value, it would only contribute a 2% increase to the overall portfolio. Is it realistic to expect multiple stocks in your portfolio to double in value? The challenge lies in truly understanding 50 stocks. The more stocks you hold, the less in-depth knowledge you can have about each individual one.
Diversification can be a great way to preserve wealth, but not to create it. Rather concentrate your investments in a handful of meticulously chosen companies. You want maximum dollars behind your best ideas.
Research shows that most diversification is carried out by the first 15-20 stocks in a portfolio. The incremental benefit of adding additional stocks from 25-30 onwards adds very little value from a risk perspective.
To outperform the S&P 500, you need to have a portfolio that looks different to the S&P 500. It sounds glaringly obvious, but you can’t outperform if your portfolio looks the same as the benchmark you are trying to beat. The more shares you add to your portfolio, the more likely your portfolio will look like the benchmark.
So instead of focussing on the number of stocks in the portfolio, rather focus on the quality of the stocks in the portfolio. Having a concentrated portfolio of high-quality businesses with diversified cash flow streams, gives investors the best chance of potential long-term outperformance. Lou Simpson, Charlie Munger and Warren Buffett would all agree.
