There are three ways to become rich.
Become a celebrity
Run your own business
Hold shares of successful businesses
First two options are active ways while the third option can be carried out passively as well. Stock market is one of the best places to build wealth. In the stock market, there are going to be hits and misses. Let’s say you have 2 lakhs to invest in stocks. You do your research and then decide to invest in only one stock because you have complete conviction in the company’s future prospects. For example, 2 lakhs invested in Relaxo Footwear in 2011 is now (as of Jan 1, 2020) worth 1 crore (4900% returns). Roughly, it has delivered a CAGR of 54% which is exceptional when compared to fixed deposit returns (7-10%). Whereas, a 2 lakh invested in DLF in 2011 is only worth 1.8 lakhs today. It has not even given you returns offered by fixed deposits. If your stock misfires, your portfolio will not go anywhere. But a concentrated portfolio can make you rich. So, you keep asking this question – should I have a concentrated portfolio or a diversified portfolio?
1. Capital Preservation:
There is a famous saying which talks about diversification.
“Don’t put all your eggs in one basket”
- Miguel De Cervantes
Why do they say this? Because, when your basket is broken, all your eggs fall and are broken. You are left with nothing. When you invest all your savings in a single stock after doing detailed market research, there is still a chance of that company going bust in the future. Though this point is advocated widely, if you look at some of the top investors like Warren Buffett, Rakesh Jhunjhunwala, Mangekar, they all made money during the initial stages of their investment careers through a concentrated portfolio.
Warren Buffett invested the majority of his portfolio in American Express (during the oil crisis) and generated significant returns. Peter Lynch made a fortune by investing most of his savings as a student in a flight career company called Flying Tiger. It helped him to fund his MBA. Rakesh Jhunjhunwala made 15 lakhs in SesaGoa (during the late 80s) and it turned out to be his first major breakthrough. Professor Mankekar is a well known person in the Indian investing fraternity. He invested only in 2 companies - Pantaloon and United Spirits which made him a millionaire.
So, all these successful investors had their eureka moments and took that risk by investing a large sum of money in a single company. Had it not worked, they would have lost most of their capital. Either they were lucky or they were right in their decisions. At the end of the day, they are exceptional investors. Hence, we should consider the average investor’s life cycle. It is always better to focus on capital preservation and build a diversified portfolio with multiple stocks.It is definitely going to preserve your wealth if some companies have corporate governance issues and it loses your wealth. Some reasons why a portfolio with a lesser number of stocks is not the right solution.
We don’t have all the information. Even after 100% due diligence and scuttlebutt, there are still a lot of unanswered questions
Hence, there is always a chance of getting your stock picks wrong.Investing is an art and one can go wrong
2. Participate in multiple growth stories:
There are 5000+ stocks listed in the stock exchange. Hence, multiple companies can go on to become multibaggers. For example, have a look at the companies that have generated maximum returns in the last decade.
Note: All the stock prices are as of Jan 1, 2020
When you limit yourself to a lesser number of stocks, you limit your chances of participating in multiple growth stories. Some companies emerge as dark horses and become winners. So, there are companies that are underrated but continue to provide solid returns. We put in a lot of efforts on some companies and build conviction after understanding all the nitty gritties. But still, there are chances of this company underperforming. Investing is always a game of probabilities. You may have an 80% chance of picking up a winner. Business dynamics change and company fortunes fluctuate depending on multiple factors. There is no point in restricting oneself with limited number of opportunities by investing only in specific stocks.
For example, in 2014, a company called Mayur Uniquoters was considered a solid compounder. Several brokerage reports were also initiated with a buy call stating that the company would do extremely well after expansion. But that expansion never materialized. The stock price continues to remain at 2014 levels. At the same time, there were silent growth stories like Manappuram Finance that were never considered a great purchase in 2014. In some companies, we can explicitly say that it would not do well. But there are other companies that look very strong and poised for the next leg of growth. Still, many companies falter in delivering and meeting expectations.
3. Opportunity Cost in other firms
Opportunity cost is one of the biggest risks when you have a concentrated portfolio. Let’s say you had a 10 lakh portfolio in 2010. And you decided to invest your capital in 3 solid companies - 33.33% each - Reliance Industries, Karur Vysya Bank and Infosys. This portfolio would have been worth 20 lakhs now. Instead, if 50,000 of your capital was invested in Avanti Feeds, it would have become 17.45 lakhs. Overall portfolio would have become 1.95 crores. Had Avanti not delivered great returns, the portfolio would have been still worth 19.5 lakhs. Hence, there is always opportunity cost at stake when you have a concentrated portfolio. You miss out on other wonderful opportunities where you can make a lot of money.
4. Lollapalooza Effect on portfolio
Don’t restrict yourself. Charlie Munger coined the term ‘Lollapalooza Effect’. What does it mean?
“An individual has many tendencies and inherent biases. When all these tendencies lead together to a specific action, it results in a Lollapalooza Effect”.
Consider a stock as an example. Let’s say a company is expected to improve its performance in various ways.
Making efforts to improve top line growth
Industry is expected to turnaround
Shutting down loss making operations to improve efficiency
Improved working capital
Strong brand value
Instead of one, there are multiple levers. When all these levers work together in unison, it leads to a Lollapalooza Effect. Hence, it results in the stock providing humongous returns to the investor. Imagine the same happening to your portfolio. When you have several high potential stocks in your portfolio, and if they fire together, it ends up to create a compound effect on your entire portfolio. This effect takes place when a large number of factors come together. If you have a diversified list of stocks with different business models, multiple factors determine these businesses. Hence, when they come together, your portfolio might provide extraordinary returns.
5. You are not running the company. You don’t have 100% information
There is a saying that ‘numbers tell you everything’. When you look at the company’s financial statements, you can identify whether the company is really doing well or not? Investing is 20% quantitative (numbers) and 80% qualitative. Hence, qualitative factors also play a vital role. Some companies come up with optimistic projections but fail to achieve the promised numbers. Whereas there are other firms that sound conservative but deliver extraordinary growth consistently.
Hence, even after doing complete due diligence, there are grey areas where you don’t have complete information. To avoid any pitfalls, you have to focus on two things - buy with a margin of safety and diversify. Because, investing in one company without knowing everything about it is definitely harmful. Unless you run a company, you won’t have 100% information about the company. Hence, we invest in companies with a lot of hope and trust. There is many a slip between the cup and the lip. Companies may not deliver as promised and you might get stuck in a specific stock as your capital gets locked somewhere without any reward.
6. Black Swan
After this CoronaVirus, the term ‘Black Swan’ is widely used in social media. What does it mean? A black swan is an unpredictable event that creates an extreme impact. A book named ‘The Black Swan: The Impact of the Highly Improbable’’ was written by Nassim Nicholas Taleb. He says it is difficult to predict a black swan event and hence, it makes sense to build robustness to negative events and an ability to exploit positive events. As Covid continues to wreak havoc, we might see some airline companies shutting down. Hence, an investor who has invested all his capital in a near bankrupt airline company might lose all his capital. To prevent your hard earned money from such events, it is always better to diversify your portfolio across different stocks and different sectors.