Concentration

Concentration is an investment strategy where an investor allocates a significant portion of their capital to a relatively small number of individual investments. It’s the strategic opposite of the old adage, “Don’t put all your eggs in one basket.” Instead, a concentrated investor embraces the wisdom of industrialist Andrew Carnegie, who famously advised, “Put all your eggs in one basket and watch that basket.” Within the value investing philosophy, this isn’t a form of reckless gambling. It is a deliberate choice rooted in deep research, high conviction, and the belief that it is far better to own a significant stake in a few wonderful businesses than a tiny slice of many mediocre ones. While wide diversification aims to protect an investor from the ignorance of not knowing which companies will fail, concentration aims to generate exceptional returns by leveraging the knowledge of which companies are most likely to succeed. A concentrated portfolio is a bold statement: the investor believes they have found truly exceptional opportunities and is willing to bet big on them.

The legendary investor Warren Buffett provides a brilliant framework for thinking about concentration. He argues that for the “know-nothing” investor—someone who lacks the time, expertise, or temperament to analyze individual businesses—wide diversification is the most sensible and prudent path. Buying a low-cost index fund that tracks the S&P 500, for example, protects this type of investor from the risk of picking a few bad stocks that could decimate their savings. However, for the “know-something” investor—one who diligently does their homework, understands business fundamentals, and only buys a stock with a significant margin of safety—concentration becomes a logical and powerful tool. As Buffett's partner, Charlie Munger, has often questioned, why would you invest your money in your 20th-best idea instead of adding more to your absolute best idea? For the investor who treats buying a stock as buying a piece of a business, it makes little sense to dilute the impact of their most promising investments just for the sake of diversification.

Investors are drawn to concentration for several compelling reasons, all of which hinge on the potential for superior performance.

• Outsized Return Potential: This is the primary motivation. If you own 50 stocks and one of them doubles, the impact on your overall portfolio is a mere 2%. If you own only five stocks and one doubles, your entire portfolio jumps by 20%. By focusing capital on your highest-conviction ideas, you give yourself a genuine chance to dramatically outperform the market averages.
• Knowledge is Power: It is virtually impossible to be an expert on 50 or 100 different companies. A concentrated approach forces you to be highly selective and to know the few businesses you own inside and out. You can follow their earnings calls, study their competitors, and understand their industry dynamics with a depth that a diversified investor simply cannot match. This deep knowledge is your best defense against risk.
• Avoiding “Diworsification”: Famed fund manager Peter Lynch coined the term “diworsification” to describe the practice of diversifying so much that the portfolio becomes a collection of mediocre businesses the investor doesn't understand. This often leads to average, or even below-average, results. Concentration is the perfect antidote, compelling you to stick to your “circle of competence” and invest only in what you truly understand.

While powerful, concentration is a strategy that can cut both ways. The risks are just as significant as the potential rewards and should not be underestimated.

• Magnified Losses: The same math that works for you on the way up works against you on the way down. If your largest holding runs into serious trouble and its stock price is cut in half, your portfolio will suffer a devastating blow. A single, catastrophic error in judgment can wipe out years of gains.
• Extreme Volatility: Concentrated portfolios are almost always more volatile than the broader market. They will experience much larger swings in value, both up and down. It requires immense psychological fortitude and emotional discipline to watch a large portion of your net worth fluctuate wildly without panicking and selling at the worst possible moment.
• The Temptation of Overconfidence: There is a fine line between conviction and hubris. An investor who has had success with a concentrated strategy may become overconfident, mistaking luck for skill and taking on even greater, unjustifiable risks.

There is no single “correct” number of stocks for a concentrated portfolio. Charlie Munger has suggested that an individual may only need three wonderful companies in a lifetime to become wealthy. For most investors, that level of focus is too extreme. A more common approach is a “focused portfolio” of perhaps 10 to 20 carefully selected businesses. This is concentrated enough to allow your best ideas to have a meaningful impact, while still providing a buffer against a single company-specific disaster. Ultimately, the right level of concentration for you depends on three personal factors:

• Knowledge: How deep is your understanding of the businesses you own?
• Temperament: Can you stomach the volatility without losing sleep or making rash decisions?
• Time Horizon: Are you investing for the long term (5+ years), giving your investment theses time to play out?

Concentration is a professional's tool. In the right hands, it can build extraordinary wealth. In the wrong hands, it can lead to ruin. It demands discipline, patience, and above all, a commitment to lifelong learning.