2006-11-10 / Columnists

Focus On Financial Affairs

Concentrated Portfolios: The Right Kind of Risk for Some Investors

Stephen J. Levine is an independent financial advisor. For more information on this topic, readers can contact him at 257 Beach 126 th Street, Belle Harbor, NY 11694 or 516-295-1410.

Volatility in the stock market often causes wary investors to reconsider their love affair with the latest investment fads. Remember the so-called "new economy"? As a result, some investors are beginning to discover the concentrated portfolio a tried and true investment technique that delivered decades of superior performance for such investing legends as Warren Buffett, Marty Whitman, Michael Price and Mario Gabelli.

The History and Future of Managed Money

A limited number of holdings, and a long-term approach, have been major factors in the positive returns posted by some of history's greatest money managers. While the investing public has enjoyed the benefits of professional money management since the 1980s, when they discovered mutual funds and expressed a willingness to pay professional managers to select investments, most investors have not yet tapped into the benefits of professionally managed concentrated portfolios.

Mutual funds provide professional management, but they generally hold between 50 and 500 equity positions. The reason most money managers offer only fully diversified portfolios is that the managed money industry developed in an era when investors were predominantly institutional. Corporate employees, reporting to their Board of Directors, keep score differently than most individual investors do. Boards don't care if they beat the index-their goal is not to underperform it. Institutions want a management approach that produces diversified, stable, consistent portfolios that perform at or near their index without big swings.

Many individual investors, on the other hand, want to grow their investments substantiallypreferably in excess of the return produced by their designated index benchmark. Investors in a wealth accumulation posture, who don't intend to use their assets for seven or more years, can and should be taking more risk than most index funds provide. Rather than seek growth through small- or mid-cap equities, which historically have long periods of underperformance versus large-cap stocks, many aggressive investors are turning to concentrated portfolios.

The Benefits of Concentration

Recent analysis indicates that portfolios begin to behave more or less like an index once you get beyond a dozen or so holdings. At that point, the effect of good securities selection begins to be diluted by the size of the holdings. This finding makes sense-you diversify your portfolio so that, if you make a poor selection, it will be such a small part of the portfolio that it can't really hurt. On the other hand, if you pick a real winner, and it's only 1.5% of your portfolio, how much can it help overall portfolio performance?

While many "new economy " stocks have faded into obscurity, savvy money managers can still identify quality companies that remain overlooked. Concentrated portfolios holding these stocks often deliver competitive results in today's market environment and may stand poised to deliver additional positive news as investor psychology returns to fundamentals-based decision-making.

The Risks of Concentration

Concentrated portfolios are an aggressive and highly volatile approach to investing and should be viewed as complementary to a stable, highly predictable investment approach. Because concentrated portfolios invest in only a few stocks, they are much more likely to experience sudden dramatic price swings during volatile markets. Also, the rise or drop in price of any given holding in the portfolio is likely to have a larger impact on portfolio performance than would the rise or drop in the price of a single holding in a more diversified portfolio. While a concentrated investment strategy does not guarantee investment success-concentrated portfolios do offer growth-oriented investors the potential to earn higher returns than those provided by more broadly diversified portfolios.

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