FOOL ON THE HILL
Defy the Market: Concentrate

The adage, "Don't put all your eggs in one basket," may well be a poor bit of advice for the motivated individual investor who has the drive and ability to locate great investment ideas. A concentrated portfolio strategy aims to beat the market by limiting stock holdings to just a handful of positions, each of which has clear valuation upside, based on thorough research of the company's fundamentals. It's a strategy that will maximize your best ideas, give you real confidence in your portfolio, optimize your time studying investments, and allow you to defy the market, no matter what its direction.

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By Matt Richey (TMF Matt)
May 21, 2002

Investors often debate the optimal number of positions within a stock portfolio. Until recently, I had targeted about 20 equally weighted holdings, thus making a 5% allocation a "full position." I would fill up my portfolio with as many good 5% ideas as I could find, holding the remainder in cash. The problem was I could rarely find enough great ideas to keep a full portfolio. I had perhaps five gems, but at 5% per position these would only represent 25% of my investment capital; the remaining 75% of my capital was in less inspiring opportunities.

Having thought through this dilemma and in doing some related reading on the subject, I've become convinced that a concentrated portfolio of 8 to 10 stocks has overwhelming advantages for the motivated individual who aspires to beat the market. Let's take a look at some of these advantages.

Maximize best ideas
The first and largest advantage of a concentrated portfolio is the ability to maximize your best ideas. Let's face it: Great investment ideas are tough to come by. Even in researching companies on a daily basis, I only find super-attractive opportunities every so often. Sometimes they come in spurts, but all in all, undervalued stocks of well-run companies are relatively few and far between, especially given my limited circle of competence.

But when I do find a gem, its investment thesis is so clear to me that I just know the stock must eventually go up. It's when I have this type of clear conviction that I want to buy. And with these opportunities being so rare, it only makes sense to take advantage of the occasion and make it a meaningful portion of my portfolio. For me, in targeting a portfolio of 8 to 10 positions, a 10% allocation per position makes sense.

I believe the ability to make concentrated portfolio bets is one of an individual investor's greatest advantages. By way of contrast, most mutual funds are required by law, prospectus, or the dictates of their own large size to own 50 or more stocks. How many of those 50 positions represent the fund manager's best ideas? Unlike the fund manager, you the individual have the freedom to concentrate your capital in only those stocks that you've determined to have meaningful valuation upside based on a thorough assessment of the fundamentals.

Attain real confidence
I believe many investors have a false sense of confidence in a portfolio that's invested in a little bit of everything. The appeal of wide diversification -- say, 50 or more stocks -- is that you can make an error in stock picking, and it won't kill you. Also, there seems to be some psychological appeal to the fact that if you own a little bit of everything, you always own something that's going up -- in other words, you're always winning, never flat-out losing. The problem is this mentality is a recipe for mediocrity. A real sense of portfolio confidence comes from truly knowing each of your holdings and having a clear conviction of their undervalued nature.

This rationale for having confidence in a concentrated portfolio flies in the face of conventional wisdom. This so-called wisdom, which you've no doubt heard, says, "Don't put all your eggs in one basket." The assumption here is that diversification equates with safety. But statistics prove that this is a false assumption. When it comes to market risk -- that is, the ups and downs of stocks overall -- diversification is grossly overrated as a means of security. Joel Greenblatt explains this uncommon-sense truth in his excellent (albeit somewhat unfortunately titled) book, You Can Be a Stock Market Genius. In it, he writes:

If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year's return falling between -8 percent and +28 percent are about two out of three.� What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one year really must be immense. Who knows how the crazy movements of one or two stocks can skew results? The answer is that there is an approximately two-out-of-three chance that your return will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks.

As you can see, the statistics prove that there's no basis for confidence in spreading one's eggs across every conceivable basket. A much better approach -- one that you can have genuine confidence in -- is to carefully select a few baskets for your capital and then watch those baskets very closely.

Optimize your time
If you're going to put your eggs in just a few baskets, it's important to be realistic about the time demands of effectively watching your portfolio. Optimal buy/sell/hold decisions can only be made when you have conducted thorough research -- both initially and on an ongoing basis.

Think how much time it takes to read press releases, 10-Ks, and 10-Qs; listen to earnings conference calls; and track a company's financials and valuation in a spreadsheet. For me, doing this type of ongoing research for just one company can easily take five hours per quarter. Multiply that figure (or your own modified estimate) by the number of holdings in your portfolio to reach an approximation of how much time your investment portfolio demands. If the five-hour estimate holds true, then it only takes eight holdings in order for your portfolio to demand a full work week of your time each quarter.

Given the reality of how much time it takes to effectively follow even one stock, you can see the time advantages of holding just a few well-selected stocks.

Defy the market
The final advantage of a concentrated portfolio strategy is that  just because the market zigs doesn't mean your portfolio can't zag. You're not invested in "the market"; you're invested in a custom selection of undervalued businesses. Just because brilliant investors like Warren Buffett and Bill Gross say that stocks are currently priced to return 6% to 7% annually -- and I believe they're almost certainly right -- doesn't mean that you can't achieve annual returns of at least twice that amount. With a focused portfolio, you can pick your spots and defy the market.

Based on all of these advantages, I'm personally resolved to target a portfolio of 8 to 10 positions. Practically speaking, this means buying in 10% allocations. If I find only six good stocks, then I may only be 60% invested in stocks. I have no problem with holding cash until I find suitable opportunities. Right now, my top nine stocks make up 68% of my portfolio's value, so I still have a ways to go in tightening up my own portfolio's focus.

I'm sure the debate about the optimal number of portfolio positions will rage on. Not every investor will be comfortable with a portfolio as concentrated as my own. The adage "Know thyself" applies here. What matters is having a strategy and being purposeful and disciplined in pursuing it.

Matt Richey is a senior investment analyst for The Motley Fool. By the way, "senior" just means he's been learning investment lessons -- many the hard way -- for a while. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.