The Warren Buffett Challenge

The question of diversification is a complex one, and among investors, a divide seems to have developed between two major investment approaches: the Graham-Davis-Lynch folks, who advocate broad diversification, and the Fisher-Nierenberg-Buffett-Munger camp, which advocates very little diversification.

Without getting into the all-too-philosophical debate on the relative (de)merits of diversification, it is important to remember that both approaches can lead to enormous investing success.

The broad swath
Fool co-founders David and Tom Gardner tend to advocate the Graham-Davis-Lynch approach in their Motley Fool Stock Advisor newsletter. The reason? If you're not a professional money manager, you may not have the stomach to watch a concentrated portfolio gyrate with regular volatility. A sudden drop could very well cause you to sell at a short-term loss out of fear for your long-term savings. Trust me: That is the worst action you could possibly take.

To avoid that scenario, consider a basket of 20 to 40 stocks (David and Tom currently offer 60 active recommendations for subscribers). If two or three happen to precipitously drop, the volatility will still be nothing more than a drop in your portfolio's bucket. You'll continue holding and adding to your positions for the long term -- and that is truly the key to investing success.

Take the challenge
But let's say you want to be concentrated and hold a portfolio of just three Stock Advisor recommendations: the best performer and the two worst performers. If that were the case, you'd be the proud owner of Quality Systems, which is up 679%, Krispy Kreme -- down 86% before being sold in the portfolio -- and Possis Medical (Nasdaq: POSS  ) , sold for a 42% loss.

Well, Mr. Concentrated Portfolio, if you had held just those three positions, your total average return would be 183% -- nearly triple what David and Tom have achieved with their 60 positions.

That, after all, is the rationale for a concentrated portfolio: Your winners will blow away any losers.

Nervous about holding a portfolio with significant positions in fewer than five stocks? Maybe you should be. If you're not a master investor, it's difficult to know just what the biggest winners of the future will be. It is not, however, unprecedented. Back in 1987, Berkshire Hathaway held more than $2 billion in three companies: Capital Cities/ABC, GEICO, and Washington Post. Of course, the cost basis for those positions had been just $573 million. That is the potential reward for more skilled investors who take the Warren Buffett Challenge.

Then there are folks like Chuck Royce and Whitney George -- with 14% annualized returns at Royce Premier since 1991 -- who let their 35 best small-cap picks account for 80% of the fund's portfolio. The reason? "Due to the greater efficiency in this zone of small-cap stocks, we believe that a concentrated portfolio strategy is a more effective way to capture the returns available within the sector." Today, their top holdings include IPSCO (NYSE: IPS  ) , Lincoln Electric (Nasdaq: LECO  ) , Simpson Manufacturing (NYSE: SSD  ) , and Thor Industries (NYSE: THO  ) .

Foolish final thoughts
To succeed in this challenge is not easy. It requires patience, research, and the diligence to throw a lot of good research away. With 8,000 or so companies trading on the American markets, that can be a daunting task for individual investors. That is precisely why David and Tom offer Stock Advisor. For novice investors seeking broad diversification, the Gardner brothers offer 60 active recommendations and two additional picks each month. As a whole, those recommendations are beating the market by more than 40 percentage points.

For more experienced investors, the newsletter can act as a sieve for superior companies. And with your own due diligence, your concentrated portfolio of superior Stock Advisor picks can destroy the current market averages.

This article was originally published on Nov. 10, 2005. It has been updated.

Michael Sarill does not own shares of any company mentioned in this article. Royce Premier is a Motley Fool Champion Funds recommendation. The Motley Fool has adisclosure policy.