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Fool On The Hill

Tuesday, February 9, 1999

An Investment Opinion
by Warren Gump

Higher Returns, Higher Volatility

An increasing number of articles touting the benefits of concentrating investments into just a few vehicles seem to be flying around. In fact, most writers here at the Fool concur with that line of thinking, believing it's better to invest in only a few top-quality stocks rather than a whole bunch. While an excellent strategy for many investors, be sure not to ignore the fact that focused investing usually increases the volatility of your portfolio. That's not a bad thing -- it's just an outcome you have to be comfortable accepting.

The benefits of a non-diversified portfolio are numerous. Foremost is that owning only a few stocks will force you to be more selective. Think of a situation where you own 9 stocks and limit yourself to owning only 10 stocks. You've saved up enough money to make an additional purchase and have a list of eight prospects. Of the eight, however, you can only pick one. You will be forcing yourself to make a decision about which stock offers the greatest long-term potential. Not always an easy task, but one that will force you to evaluate the prospects of each company and choose the one that seems most likely to succeed.

Owning only a few stocks also keeps your portfolio management task manageable. Before investing in a company, you need to spend time learning about its industry and business model. After owning a stock, you should invest more time (at least once a quarter), monitoring the performance of the company. Unless you spend all day researching your portfolio, tracking more than a few stocks will prove to be quite a chore. Maintaining no more than 5-15 stocks (everyone defines "focused" a little differently) improves the likelihood that you'll develop a good understanding of each company and its prospects.

Assuming that you have thoroughly done your research and the stocks perform as expected, engaging in a focused strategy leads to stellar returns. You have a group of high quality thoroughbreds in your stable, all galloping ahead in the business world to make you more money. The picture is serene and beautiful. No laggards are pulling down the performance of your portfolio. Your returns are zooming upward. Until, that is, one of your horses is injured.

Even if you were the best stock picker in the world, your companies and stocks are going to run into short-term and possibly long-term problems. A competitor might introduce new products, the government could propose or enact new regulations, or your company might just make a mistake. When that happens, each tumble by a stock in a focused portfolio will have a noticeable adverse impact.

It might be a little easier to comprehend with a numerical example. Let's assume that you have a five stock portfolio. Four of the companies have a good year and their stock prices increase by 15%. One of the stocks, however, is a true superstar and soars 50%. Combining the results for this five stock portfolio results in a total return of 22%. The strong advances by the one superstar increased the portfolio's total return by 7 percentage points over the 15% gain achieved by most of the stocks.

In a 30-stock portfolio, however, the impact of having one superstar performer will not be as significant. Assuming that 29 of the stocks increase 15% and one soars 50%, the total return of the portfolio will be 16%. The superstar's surge only boosts the overall portfolio performance by 1 percentage point. Moves in any one security are dampened by a diversified portfolio.

When the news on stocks in a portfolio is positive, having a focused portfolio is advantageous. On the other hand, when disappointing news hits a stock in a concentrated portfolio, the bad news has an equally powerful adverse impact. If the signs were reversed on the above examples, investors in a concentrated portfolio would not be quite so happy. The holder of the five stock portfolio would be down by 22% compared to a 16% decline for the holder of the diversified portfolio. Always remember that stocks go both up and down in the short- and medium-term.

What does this information mean to an investor? A concentrated portfolio will usually have higher volatility than a diversified portfolio. Moves of individual portfolio will have a more significant influence over returns than the performance of the market at large. In a diversified portfolio, the moves of the overall market tend to have greater importance than the moves in any individual stocks.

If you utilize a concentrated strategy, you need to be prepared for the increase price volatility associated with such a portfolio. The highs will be higher, but the lows will also be lower. If you can't tolerate the "lower lows," you should be cautious about pursuing a focused strategy. If you are going to be frightened out of stocks in a downturn (how did you respond last October when uncertainty was at its peak?), you will likely end up selling at low prices, locking in your losses.

Obtaining the "higher highs" possible with a concentrated portfolio is really exciting and rewarding. You've got to recognize, however, that it isn't a free ride. To benefit from such a strategy, you have to feel confident about your ability to pick good stocks (like any Fool). In addition, you must be willing to accept the more dramatic price moves (both up and down) that will occur on a daily, weekly, quarterly, and annual basis.

Call Your Boss a Fool.

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