Concentration Can Be Good for Your Wealth

While addressing a group of graduate students at the University of Florida in 1998, Berkshire Hathaway's (NYSE:BRK-A) Warren Buffett stated: "If you really know businesses, you probably shouldn't own more than six of them. If you can identify six wonderful businesses, that is all the diversification you need and you will make a lot of money. Very few people have gotten rich on their seventh-best idea."

More reward, less risk?
Now you might respond, "Sure, that sounds great, but I can't take the volatility. Don't I need a diversified portfolio for stability?" Not necessarily. In a classic study from 1968, professors John Evans and Stephen Archer found that portfolios with as few as eight to 10 securities had volatility levels that were virtually identical to that of the market.

And if you think a 1968 study is too old to be good anymore, think again. Data collected by University of Rochester professor Bill Schwert shows that volatility was actually higher in the 1930s, and there were many spikes of volatility before and after the 1930s that exceeded today's volatility. In other words, what we think is unprecedented volatility really isn't.

Lessons from a classic
John Maynard Keynes, the famous British economist, was one notable proponent of the concentrated strategy. Most investors know Keynes best for his economic theories, but he was also a quintessential stock investor, concentrating on a few holdings in diverse sectors. Keynes reasoned that investors should hold investments with opposed risks; that is, investments that tend not to rise and fall in tandem with one another.

The classic example is oil and airlines: When oil prices are high, oil companies tend to do well. But airlines often do poorly, because their cost of fuel rises. Conversely, when oil prices fall, oil companies' profits drop, but airlines benefit from lower costs.

Of course, you don't need to take it to the point where every stock you own needs to be offset by a corresponding yang, but a concentrated portfolio should avoid overlapping businesses. The portfolio should be a selection of dissimilar stocks selling at discounts to their probable intrinsic value, steadfastly held through thick and thin, perhaps for several years, until either they have fulfilled their promise or it becomes evident that they were mistakenly purchased.

A modest value-oriented guide
I prefer to take a value tack in building concentrated portfolios. Keynes was a value guy in the Ben Graham mold, and so was Buffett before Berkshire Hathaway became the sprawling entity we know today. I favor lagging price performers (the more chronic the better) that pay dividends and sport debt-to-equity ratios of 1 or less, although I'll expand that figure to 5 for large-cap financial institutions. I also prefer a market cap of at least $1 billion and a 15-year operating history as a public company.

The following is a custom-made example of a concentrated stock portfolio with an old-school philosophy -- focusing on companies that make tangible stuff. The portfolio includes a major pharmaceutical, a publisher, a furniture and automotive components maker, a packaged food producer, a financial and industrial conglomerate, and a commodity chemicals and ammunition manufacturer. In short, it's a concentrated portfolio of little overlap and a lot of tangible stuff.

*Allowance for GE's finance unit. Source: Capital IQ, a division of Standard and Poor's.

I can attest firsthand that a six-stock portfolio is volatile. If that's an issue, the portfolio can be expanded to accommodate 10 (per Evans and Archer) or even 12 issues, while adhering to this same philosophy.

Superior wealth creation requires a concentrated effort -- one that we've been lead to believe is foolish. But a sufficient body of research suggests a concentrated portfolio cobbled by an experienced, enterprising investor isn't so foolish after all. Or maybe it is Foolish.

Longtime Fool contributor Selena Maranjian also thinks fewer stocks can bring you better returns. Let her point you to some great investments that do the heavy lifting for you.