Dear Vivek,

Dear Basant,

There is no confusion. Just want different views.

The question whether midcaps or large caps should be viewed in terms of the time an investor is willing to hold onto his portfolio. For shorter durations of time midcaps will fluctuate wildly falling 40% with the market but when that happens investors forget that this stock also rose 40% with the market.

A risk taking investor should always invest in midcaps because it defines the scope of companies that can grow faster, quicker and longer. A large cap generally indicates a mature or a maturing business where the risks are limited but so is the opportunity for growth. A few points should be noted while investing in midcaps:

1) They should be sector leaders

2) Their financials should be strong.

In case these two conditions are met I do not think that there could be a problem in choosing between a midcap and a large cap. Finally as we said midcaps rise equally as fast as they fall so while they would be subject to higher volatility we cannot say that the chances of losing money is higher. That is as long as we have a long term view. Which in any case is a a sine-quo-non for investing in equities as a class.

A diversified portfolio tells you two things. One is, your standards are falling. Or the other thing, the markets are incredibly cheap. So yes that itself gives you discipline. If you are finding it incredibly difficult finding your dozen good ideas, again it tells you that either your standards are way too high, so you are an academic or the market is probably overvalued at this point – Vinod Sethi Former Fund Manager at Morgan Stanley

Now why diversification is important:

1)     It cuts down volatility. Lower volatility would lead to a higher Sharpe ratio. This ratio is sued by most of the fund mutual fund analysts to determine which fund is good. The best performing fund on the basis of Sharpe ratio hold over 100 stocks.

2)      There will always be a cause for celebration because some sector will always outperform. So the portfolio will never underperform the market.

3)      Event risks are cut down that means if a mutual fund is holding WIPRO and if WIPRO issues a profit warning with a 50% fall in price the fund that has diversified itself through a lot of companies would not get impacted since each company constitutes a very small percentage of its portfolio.

What are the pitfalls of diversification?

1)     I think that a person who diversifies into more then 25- 30 stocks is unsure of the stocks that he holds.

2)      Now if some one asks us what is the best large cap software company we would say Infosys. But a portfolio that is diversified will have Satyam and Wipro because the fund manager says what if Infosys does not do well. We could ask the same question what if Infosys does as well as we thought and Satyam underperforms. Diversification allows the weeds to get into our flower garden.

3)      Most of the times people who hold diversified portfolios want to have a bit of every rally in the market. In the example that you gave about Sundaram Select fund holding 194 stocks assume that the fund held an average bet of 0.5% in each stock. If it gets a ten bagger the portfolio moves by only 4.5%. Seasoned investors would know how hard it is to get a ten bagger and having got one it has made minimal impact to the NAV of the fund.

4)      The story does not end there as soon as the stock starts moving the manager will sell out to book profits because otherwise this stock’s weightage shall increase in his portfolio casing a shift away from the diversification mantra.

5)     Buffet preferred to hold a concentrated portfolio. At one point in time he had put half of his corpus to a single stock “American Express”.

6)     Mutual fund managers have quite a few problems a) they have a higher impact cost b) they need to keep their Sharpe ratio high c) Investors are mostly worried with wild NAV swings and therefore managers want to control volatility.

7)     Peter lynch the best fund manager of all times held over 1400 stocks in his fund but said that as a fund manager he had no option. On the number of stocks one should have in his portfolio he said

” Owning stocks is like having children – don’t get involved with more than you can handle. The part- time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any one time.”

The Robert Hag storm Study Results of Concentration

STEP – 1 The Different Sample Size

Computer randomly assigns from 1200 companies, 12000 portfolios of various sizes. For 10 year returns:

3000 portfolios covering 250 stocks each.

3000 portfolios covering 100 stocks each.

3000 portfolios covering 50 stocks each.

3000 portfolios covering 15 stocks each

Step 2 Result of the analysis

                    The Final Answer

Study 2:

In study it was indicated that the market risks reduces with an in crease in the number of stocks in the portfolio but only to a certain extent.

So increasing the number of stocks beyond a point (8 stocks) does not significantly reduce the market risk.

Yes,Vivek my portfolio can get concentrated over time but I would love it if moderate holdings really outperform.Just think Credit Capital Venture I bought(and am holding still) at 8 Rupees (There was some reduction in capital)and ignored by me  as unimportant for past 9 years is now I L & F S investment managers quoting at around 140(yesterday)Xb 1:2.There have been scores of  shares like that for other investors  also in the past and there are hundreds like that today and I hope to do a repeat and ignore and let the moderate holdings blossom... but it can turn ot as you say that is a possiblity I cannot rule out ...If I had the luxury of making company visits and interacting with managements  and having an organizational backup I would love to have a few hundred shares in my portfolio but my limitations puts the brakes since I would  otherwise lose all  control .I have heard of someone  having 240 stocks..no point at all in having so many.

Good point ,Vivek.

Very well written"deepinsight".

Glad the simple thoughts are appreciated.

Investment (for me) is all about learning to get to high conviction on ownership. However it’s not possible to get there in a hurry. As the saying goes “it takes a long time to make an old friend”.

The number here is not important. It could be one, five or ten.

20% is on “discovery/search” phase of finding those high conviction companies. (Some work out – some may not). Some become old friends some just acquaintances…

No percentage is allocated for trading. Have no negativity for traders. It’s just a different ball game. Different mind set, different rules to win, different temperament.

__________

One angle to discuss the concentrated portfolio is through the lens of “risk”.

In high conviction companies we eagerly want to take the “risk” through more ownership.

In speculation/discovery/search phase we want to limit or distribute the “risk”.

The best example of risk takers are entrepreneurs who put everything they have in their own company. Talk about concentrated “risk”.

____________

One of the lessons I learnt from the past was not about losing through having too concentrated a portfolio – it was rather not building/adding more on companies where your conviction grows. (as the company proves itself and becomes an old friend)

i.e.  In other words if one was an owner in Infosys – as the investor saw it performing quarter on quarter year on year – it would have been smart to keep adding to that position versus trying to find the next Infosys. 

One last thought on this - just as a quick reminder and stretching the friend analogy, as Mama always says “you need to choose your friends carefully”!

Excellent article....DeepInsight......especially.....

Risk cannot be defined by mathematics or share-price movements.  Rather, investors create risk by chasing stocks indiscriminately, by failing to do their homework.

http://money.cnn.com/2007/09/06/pf/zweig_september.moneymag/index.htm - How many stocks should you own?

The answer is a lot more, and a lot fewer, than you probably think.

With the stock market as bouncy as a beat-up couch, you may be thinking it's time to focus on a small number of stocks that you know really well. What better way to keep returns up and risk down?

Conventional wisdom and new academic research certainly seem to suggest that this is the way to go. Many financial planners and brokers will tell you that a portfolio of as few as 12 stocks (and up to 30) will sufficiently diversify your holdings.

And three recent studies have found that individuals who own fewer stocks do better than those who own many.

However, as is often the case with conventional wisdom (and academic research), there's a lot more to the story. Fact is, if you build your portfolio entirely on the principle of "less is more," you're a lot more likely to end up with less than more. Here's why and what to do instead.

The idea that 12 to 30 stocks are all you need dates back at least to the 1960s, when academics, including Burton Malkiel, author of the classic "A Random Walk Down Wall Street," concluded that that's what it took to eliminate most of the risk from a portfolio. (They usually defined "risk" as the chance of suffering big swings away from the average market return.)

But back in the days of hula hoops and transistor radios, and before computer-generated trading became common, stocks didn't bounce around the way they do today. In 2001, Malkiel found that it took 50 stocks to get the risk reduction that 20 used to provide. Others estimate that true diversification requires hundreds of stocks.

Just recently, however, researchers studying the performance of individual investors have discovered something that, at first glance, seems electrifying: The more concentrated a portfolio is, the higher the returns. One study found that investors whose portfolios were dominated by one or two stocks outperformed the most diversified stock owners by 0.8 to 4.8 percentage points annually on average. That's a huge gap. And roughly 8 percent of the top performers had portfolios concentrated in a single stock.

So the heck with diversification, right?

Well, not exactly. First, the least-diversified investors frequently lagged the market; they just lagged by less than investors who held more stocks.

Second, because stock returns are so uneven, the "average" undiversified investor doesn't really exist. At any given point, there are something like 10,000 stocks in the United States. Most of them are mediocre, but a handful are what Bill Bernstein of Efficient Frontier Advisers dubs "superstocks," capable of delivering gargantuan returns for years. Think Microsoft in the '90s, when it returned 9,000 percent. (More often superstocks are lesser-known companies.)

Across a large group of people whose portfolios are mostly in one or two stocks, the lucky few with superstock portfolios will make the group's average return look great, even if the vast majority of individual members have lousy or middling results.

On the other hand, investors who spread their bets across dozens of stocks have only a slightly better chance at catching a superstock. And if they do land one, it won't have nearly as much impact on their portfolios, or on the group's average return.

So the real story is that you need a lot of stocks to be adequately diversified, and you need a concentrated portfolio to give yourself a shot at striking it rich. An unsolvable catch-22? Hardly. In fact, you can have it both ways by employing a straightforward, two-part strategy.

First, direct 90 percent of your U.S. equity allocation into a total stock market index fund that automatically gives you a stake in thousands of companies. That guarantees you a piece of every superstock that already exists or might emerge later - and, more important, it means you'll be adequately diversified and your investing costs will be at rock bottom.

Then pursue your search for the next Microsoft or Google by researching the daylights out of a very small number of companies and putting the remaining 10 percent of your portfolio into your one-to-three best ideas. This way you'll let yourself have a little fun. You will also minimize your risk and maximize your hope.

http://www.ft.com/cms/s/0/81510704-c623-11dc-8378-0000779fd2ac,s01=1.html - Whitney Tilson: Strong stomach? Concentrate that portfolio

Cipla was a block buster company in the 90'd not sure what they did then or do not do now that created such kind of shareholder returns.

HI

With the issue of concentrated vs diversified portfolios, my personal experience has been this:

As you can figure out, I do not have the conviction. Somehow, I am more convinced when I have little to lose , and become a confused wreck when I have everything to lose. Having clarity of though, conviction and level headedness at such times can be priceless. Basant is surely one of the select few who appears to have 'it'.