Portfolio - Concentrate or Diversify

Concentrated investing is intense and driven by a high level of information and involvement. For most small investors, a diversified portfolio is the simplest way to invest in equities

Investors can be adamant sometimes. Some of them refuse to accept that it is not easy to get wealthy with equity.

Many are simply lucky with equity and fail to see the strategic choices they need to make to be successful equity investors. A diversified portfolio is the simplest way to participate in equity markets and earn average market returns, which are not bad actually. For those seeking significantly more, one critical factor matters most: the extent of concentration in the portfolio.

The promoters of a business hold the finest form of a concentrated equity portfolio. Many of us drool at the personal wealth of entrepreneurs. The list of the world's richest people is made up primarily of equity investors, inspiring so many of us to see equity investing as the most democratic and legitimate way to build wealth. But for every entrepreneur that succeeds, there are many that fail. That in essence is the power of the concentrated portfolio. It may be enough to hold the stock of just one company to build a fortune, if the company has built a valuable business. But should that business fail, you may face bankruptcy. That is why concentrated portfolios are most suitable for someone with the orientation to create, build and run a business, than for someone choosing to be a dormant equity shareholder. Successful entrepreneurs invoke awe and envy, but it takes a lot to be one. The nicest thing happening at present in India is that a large number of youngsters are choosing to create a business than pick up a job. This shows the swing away from fixed income seeking behaviour to preference for a concentrated strategy to build wealth. This significant modification in risk profile of people while choosing careers should bring great benefits to equity investors as a community. The successful entrepreneurs will deservedly make the most.

Angel investors, private equity investors and venture capitalists are the next rung of investors with a concentrated investment strategy. They seek high returns and are willing to invest in a small number of businesses to earn that. They are also `inside' investors (as against public shareholders) who seek more information and a more significant role in running the business. Many of them are on the boards of companies they invest in. They mentor the business to achieve scale and size. Given the engagement levels, they have large and significant holdings in a few businesses and take on the risk that some of them may fail. But a few good ones make up for such losses, again because of their concentrated holdings and high stake.

It is quite common for successful entrepreneurs to use their wealth to seed and fund new businesses. The objective is not merely altruistic. There is tremendous business sense in investing significant stakes in a few businesses, without having to actually run them from the front. These investors are only doing what they know to do best, but earning a higher return from being strategic investors. Institutional investors such as sovereign wealth funds, hedge funds, pension funds and endowments also take on strategic investments in growing businesses. This is the institutionalised form of concentrated investing, where the involvement in the business is not as deep as that of the inside investor, but the stakes are significant to make a difference to their return.

When individual investors choose DIY (do it yourself), they should look at the approach of these professional investors who hold a large stake in a few stocks. The approach is intense and driven by a high level of information and involvement. Institutions invest in research, data and talent to choose and invest strategically.

The extent of involvement de pends on the stake acquired. If there is a clear vision about where the business should go, the investor is willing to work towards making it happen in return for a significant stake. If the involvement is as a strategic investor, they work with the board and the management and will be willing to process and analyse information about the business on an on going basis. Therefore, concentrated investing is only for those who can do the hard work and stay patient.

Strategic investors do not worry about every day price or quarterly results. The frustration of promoters about quarterly results and market reaction comes from the relative insignificance of this number for their own strategic reasons. But public investors and institutions such as mutual funds, that hold diversified portfolios, need dynamic information for their strategies. They represent the other end of the investing spectrum, where they hope to earn a few percentages more than the benchmark, by using a large diversified portfolio. The intensity of research and need for information is lesser and restricted to publicly available information. The focus is on diversification and risk reduction, and holding periods can be shorter.

A concentrated equity portfolio is a choice that lies at the opposite end of the diversified portfolio. I have noticed with amusement how investors eulogise Warren Buffet and then mindlessly buy multiple stocks, which they believe hold value. Warren Buffet is the world's most successful investor, because his investing style is what we described above--concentrated and strategic. He buys large stakes in businesses he understands, and holds them with patience. He also specialises in picking them up when the going does not look good. Wealthy investors in equity are quasi-businessmen who are deeply into the few businesses they hold.

Where does that leave the retail investor who likes DIY? A few with the penchant for business and research do really well. They go much beyond tips, news and media quips, to understand how a business is doing. They work in groups, analysing businesses thoroughly. They invest after careful selection, in a few stocks, usually not over 15-20, and stay invested for the long term. This is a high-return, high-involvement concentrated investment strategy, not in the mode followed by most common investors.

Those who simply buy this and that, hold a large number of stocks, and brag about the few that have done well for them, might be misleading many others. The more a portfolio holds, the more diversified it gets and, therefore, it gets closer to average performance. When it comes to investing, there is nothing right or wrong. There is only risk, return and diversification--or the lack of it, if you will.