1. Time constraint: When you maintain a diversified portfolio you don’t get enough time to understand the stocks in your portfolio. Hence there is a higher risk that you might miss out on something important about the company which you are bound to know and you might not know the company fully and you may not find enough time to follow the company fully.
2. Relying on others work: Also there is a higher risk that you might buy the company based on research done by some other investor and without doing your own research which may prove dangerous. If you maintain a portfolio of 50 stocks if your broker comes up with a stock tip there is a greater chance you might just buy it. But if you are just holding a portfolio of 5 stocks than there is very little chance you will buy it unless you get fully satisfied.
3. Forced to look for more opportunities: Further diversification also means that you will have to find 50 good stocks to invest as against 5 stocks if you have a concentrated portfolio. It is always more difficult to find 50 good stocks compared to 5 good stocks and hence some of these stocks may be companies with poor fundamentals which you were forced to buy just for the sake of diversification of risk but actually you are increasing your risk by doing so.
4. Prevents quick capital appreciation: One of the main reasons for diversification is protection of capital. But I believe the best way to protect your capital is to let it appreciate a few times. By diversifying you are trying your level best to prevent your capital multiply a few times as it impossible for a portfolio of 50 stocks to generate the same kind of return as a portfolio of 5 stocks.
5. Cost of research Vs. quality of research and time spent by the fund manager Vs. time spend by the analyst with lesser experience: If a fund manager manages a portfolio of 50 stocks he may have 10 research analysts under him who would be doing the research on these stocks. The research analysts may know in detail on these companies but the fund manager I don’t think would be able to personally study these 50 companies. But on the other hand if he just holds 5 companies he can individually study all the five companies and also he can have just 2 extremely smart analysts under him and pay them more. So it is not just the quantity of time spent but with a concentrated portfolio the fund manager can spend more quality time and he can also hire smarter people. There is a great deal of difference between a fund manager spending 5 hrs on a company and his smart research analyst spending the same 5 hrs on the company and a average analyst spending the same 5 hrs on the company. Further he can also spend more money on hiring few smart people. The cost of research may look really small when compared to the overall return generated but it is important if one takes into account the fact that the cost of research should be paid out of the management fee and hence it is an important thing for the fund manager to keep the cost of research at a relatively low level.
6. Spreading Risk Vs. Risk Assessment: I think the best way to manage risk is to assess risk in a much better way rather than spreading risk by investing in many stocks. I think with a concentrated portfolio one is in a much better position to manage risk by assessing and avoiding companies with higher risk and weaker business models rather than trying to manage it with diversification.
7. History: History shows that nobody has ever created really large wealth by maintaining a highly diversified portfolio. If we look at the top 10 richest Indians all of them have created wealth only by running a concentrated businesses and not by having a diversified portfolio. So history shows that one can never create wealth by maintaining a highly diversified portfolio. So only way to create wealth is by concentration. Even the most successful investor in the world Warren Buffet has created wealth with a concentrated portfolio and the same is the case with Rakesh Jhunjhunwala.
I believe if one understands the market fully and is smart to understand investing one should avoid diversification to reduce risk. If one does not understand investing fully instead of diversifying one should look for a smart fund manager and handover the money to him. This would be the best way to manage risk and not by diversification.
2. Relying on others work: Also there is a higher risk that you might buy the company based on research done by some other investor and without doing your own research which may prove dangerous. If you maintain a portfolio of 50 stocks if your broker comes up with a stock tip there is a greater chance you might just buy it. But if you are just holding a portfolio of 5 stocks than there is very little chance you will buy it unless you get fully satisfied.
3. Forced to look for more opportunities: Further diversification also means that you will have to find 50 good stocks to invest as against 5 stocks if you have a concentrated portfolio. It is always more difficult to find 50 good stocks compared to 5 good stocks and hence some of these stocks may be companies with poor fundamentals which you were forced to buy just for the sake of diversification of risk but actually you are increasing your risk by doing so.
4. Prevents quick capital appreciation: One of the main reasons for diversification is protection of capital. But I believe the best way to protect your capital is to let it appreciate a few times. By diversifying you are trying your level best to prevent your capital multiply a few times as it impossible for a portfolio of 50 stocks to generate the same kind of return as a portfolio of 5 stocks.
5. Cost of research Vs. quality of research and time spent by the fund manager Vs. time spend by the analyst with lesser experience: If a fund manager manages a portfolio of 50 stocks he may have 10 research analysts under him who would be doing the research on these stocks. The research analysts may know in detail on these companies but the fund manager I don’t think would be able to personally study these 50 companies. But on the other hand if he just holds 5 companies he can individually study all the five companies and also he can have just 2 extremely smart analysts under him and pay them more. So it is not just the quantity of time spent but with a concentrated portfolio the fund manager can spend more quality time and he can also hire smarter people. There is a great deal of difference between a fund manager spending 5 hrs on a company and his smart research analyst spending the same 5 hrs on the company and a average analyst spending the same 5 hrs on the company. Further he can also spend more money on hiring few smart people. The cost of research may look really small when compared to the overall return generated but it is important if one takes into account the fact that the cost of research should be paid out of the management fee and hence it is an important thing for the fund manager to keep the cost of research at a relatively low level.
6. Spreading Risk Vs. Risk Assessment: I think the best way to manage risk is to assess risk in a much better way rather than spreading risk by investing in many stocks. I think with a concentrated portfolio one is in a much better position to manage risk by assessing and avoiding companies with higher risk and weaker business models rather than trying to manage it with diversification.
7. History: History shows that nobody has ever created really large wealth by maintaining a highly diversified portfolio. If we look at the top 10 richest Indians all of them have created wealth only by running a concentrated businesses and not by having a diversified portfolio. So history shows that one can never create wealth by maintaining a highly diversified portfolio. So only way to create wealth is by concentration. Even the most successful investor in the world Warren Buffet has created wealth with a concentrated portfolio and the same is the case with Rakesh Jhunjhunwala.
I believe if one understands the market fully and is smart to understand investing one should avoid diversification to reduce risk. If one does not understand investing fully instead of diversifying one should look for a smart fund manager and handover the money to him. This would be the best way to manage risk and not by diversification.
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