Fewer Stocks Can Mean Higher Returns

We all know that diversification can help you protect your portfolio from volatility. But if you want to maximize your returns, you have to be willing to invest with conviction.

One proponent of this philosophy is renowned investor Phil Fisher, who wrote one of the investing world's most respected books, Common Stocks, Uncommon Profits. He also popularized the concept of "scuttlebutt," whereby an investor digs for the inside story on a company by talking with employees, customers, suppliers, and others who have unique views on businesses.

With respect to diversification, he said, "I don't want a lot of good investments; I want a few outstanding ones." Many great investors, such as Warren Buffett, have echoed this. Think about it -- given the market's long-term average annual gain of around 10%, if good investments average, say, 11%, and great ones average 14%, lots of good ones would give you much less growth than a few great ones.

This premise should lead us to consider focusing, or concentrating, our portfolios on just our best ideas. That can mean aiming to own shares of just the 10 or 12 most attractive stocks we find.

It can also mean investing in mutual funds whose managers choose to concentrate the assets in their care among a few dozen stocks, instead of the several hundred you'll see in many funds. The Fidelity Magellan (FMAGX) fund, for example, recently held more than 200 different stocks. Even when a fund manager hits a home run on one stock, it won't make much difference when their performance is diluted by hundreds of less spectacular performances. These days, many large-cap-focused mutual funds have begun to resemble S&P 500 index funds. They're called "closet" index funds, and they don't serve their shareholders very well, since those shareholders could get a similar performance from an actual index fund with much lower fees.

Survey says …
That much is simple common sense, but it's also backed up by some research. A 2003 report from the Michigan Business School, for example, looked at stock funds from 1984 to 1999 and found that funds with an above-median degree of industry concentration exceeded average returns by about 0.82 percentage points annually after expenses, while funds with a below-median level of concentration finished with returns 0.73 percentage points below the average. That's a pretty big difference. The researchers extended their research later and found that the concentration edge persisted.

Playing concentration …
If you want to look into concentrated (or "focused") funds, below are some with rather respectable results, relative to the overall market:

Data: Morningstar.

Of course, simply being a focused fund isn't enough to guarantee great results, or to even make that more probable. The fund's success will still ultimately depend on the smarts of the managers, and the stocks they select. There have been some concentrated funds that have done abysmally, due to some terrible investment choices by managers.

So, remain choosy in picking funds. Continue to look for managers you admire, reasonable fees, impressive track records, and ideally, low turnover. Remember also to keep your overall portfolio diversified, perhaps aiming to balance large-cap stocks with small-cap ones, domestic holdings with international ones, and possible high-flyers with reliable dividend payers.

Learn more:

• Now's a Great Time to Invest -- So Don't Blow It!
• Rescue Your 401(k)
• When to Concentrate