GEO Investing

For as long as I can remember, which is certainly a diminishing feat now that I’ve crossed the half century mark, investors have been debating “Concentration vs. Diversification” when it comes to portfolio management. Portfolio theory, as penned by value investing theorists, states that the benefits of diversification caps out anywhere between 12 and 30 stocks. 

Peter Lynch owned thousands of stocks when he managed the multibillion dollar Fidelity Magellan Fund, which logged an annual average return of 26.9% between 1977 and 1990.

Warren Buffett even chimed in on this debate, where his clever quips led many investors to conclude that Buffett favors concentration over diversification. But in reality, what Buffet really meant to convey was that if you are a professional investor, you should be highly concentrated in a few big bets, and highly diversified if you are not a professional investor, meaning investing in index funds. 

My views on this subject have definitely changed over time, but in my opinion, the answer lies somewhere in between. But first of all, let’s agree on this – whatever camp of this debate that you’re on, you gotta pick great stocks to get great returns. If you are a bad investor, you are either going to end up holding a piece of crap (concentration), or a pile of crap (diversification). 

As you might know, Peter Lynch is my investing hero, so I started my journey holding hundreds of stocks, mainly in the microcap and small cap arena, averaging a healthy year over year return for several decades. However, after doing a post mortem, I noticed that a majority of my portfolio gains were generated by less than 20 stocks on an annual basis. 

I came to find that there were also many stocks that I held in my portfolio for years that were poor performers early on, only to become huge winners. So it’s really a fluid situation, and honestly I believe it is a waste of time getting too caught up in this debate. In the end, a reasonably balanced portfolio weighted to your higher conviction bets is the way I like to go now.

However, concentrating your capital in high conviction picks is important because there is nothing worse than seeing some of your picks go up with minimal affect to your portfolio. But, I still like to have a long tail in some lower conviction stocks that could turn into higher conviction stocks as time goes on.  At times, I may hold 100 stocks and at other times less than 20.

I don’t approach diversification as a way to manage the volatility of my portfolio. I use it because, as an investor, I don’t have perfect information and most of us aren’t going to be able to think of every risk that a company will face over time. This is why some diversification can be useful. For example, inflation and supply chain risks are currently destroying the gross margins of some high conviction stocks I own, which is having a dramatic negative effect on their shares. 

On the flip side, one of my biggest winners, Repro Med Systems, Inc. (NASDAQ:KRMD), started out as a low conviction holding at around $0.10 that eventually benefited from a change in the way Medicare paid out on a certain billing code for their home healthcare infusion therapy solution, and the stock eventually became a high conviction stock that topped out at $13.00. But it took thirteen years!

To put it in greater perspective, this is how I currently try to manage my portfolio: devoting the majority of my investment capital to 5 to 7 stocks, then less to lower conviction stocks that I believe still have good potential, and then a very small amount dedicated to short term trading opportunities. 

In the end, concentration vs. diversification has to be looked at through a personal perspective. If you are diversifying, do you have time to keep up with what is going on with the companies you own? If you are concentrated, you are going to perform a deeper level of research to understand what you are investing in. Anyways, one thing is for sure, concentration vs. diversification would have not mattered this month as microcaps got destroyed. So, now is a great time to revisit your portfolio to:

  • Shed some stocks you should not own anymore
  • Add to high conviction stocks 
  • Find new stocks among the carnage 

Have a great week. 

~Maj Soueidan

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