Diversification or Focus?
When it comes to investing, the term portfolio is frequently used. An investment portfolio simply describes the entirety of assets a particular individual or company is invested in. The investments within this portfolio need to be managed and reviewed regularly – a discipline referred to as portfolio management.
There are two largely differing schools of thought on how this is to be achieved: focused and diversified portfolios. In our two-part series, we are going to discuss the basics of portfolio management. We will introduce both focused and diversified investing and the pros and cons that each of these approaches entails. For part 1, we will look into portfolio management fundamentals and then talk about the creation of a focused portfolio. But first…
What is a portfolio?
The word portfolio is originally derived from the Italian word “portafoglio” which literally describes a case in which loose sheets of paper were carried. In the context of finance and investing, a portfolio has come to mean the entire group of investments and other assets that an investor holds.
These investments can be “loose”, meaning that they can be spread across different asset classes (e.g. stocks, bonds, futures, real estate), across different countries (e.g. stocks in Germany, the UK, the US), or across different risk levels (e.g. small cap vs. large cap stocks).
Portfolio Management Fundamentals
Investments made cannot be left alone – they must be reviewed, analyzed, and monitored on a regular basis. Depending on their price development, an investor might find out that:
- His investments are not performing nearly as well as he would have expected.
- His investments seem to be facing similar price erosion – a phenomenon known as “correlation”.
Equally, it is possible that an investor needs to rebalance his portfolio to adjust for a changed personal or financial situation or his risk appetite changes. All of these circumstances could cause an investor to rethink and adjust his investments – measures of the discipline of portfolio management.
According to the American investment portal Investopedia, portfolio management describes “the art and science of selecting and overseeing a group of investments that meet the long-term financial objectives and risk tolerance of a client, a company, or an institution.”
Every investor seeks to maximize his return on investment – no surprise there. Yet, depending on their financial situation, goals and personality, investors have different levels of risk tolerance. Investors therefore always need to strike a balance between striving for maximum returns and minimizing investment risk.
In this, they either have the option of investing their resources in a small number of promising investments (building a focused portfolio) or spreading it over a larger number of assets/asset classes and countries to minimize their risk (building a diversified portfolio).
Proponents of a concentrated portfolio favor the idea of identifying and focusing on a small number of highly promising and attractive investment opportunities – oftentimes in the same asset class or industry. Their goal is to find a few investment opportunities that strongly outperform the market average (typically the stock index serves as a benchmark).
The Pros and Cons of a Focused Portfolio
Indeed, a focused portfolio has one central advantage – in theory, that is. “Focus your investments on the most promising growth stocks that can achieve large gains.” – this is the key tenet of a focused portfolio.
A concentrated portfolio usually consists of assets with high correlation – meaning that if the price of one asset goes up, so do the others. This is a two-edged sword. For if the chosen investments do not perform as expected – e.g. due to unexpected industry developments, certain unforeseeable events (“event risk”), or massive competition in a growth industry – this can lead to a massive decline in their value (and loss of capital).
Another important downside of a concentrated portfolio and its higher inherent risk is that it must be monitored and managed more closely and frequently. Especially investors with a low (and/or lower than expected) risk tolerance might experience unease and anxiety when an inevitable bear market (longer time frame of decreasing asset prices) hits.
Investors may find themselves spending countless hours worrying about and adjusting their investments instead of being free to go about their everyday. Individuals looking for a decent return on their investments with as little time investment as possible should certainly opt for diversified portfolios instead.
Focused portfolios represent a small selection of promising investment opportunities, oftentimes (but not always) focusing on assets e.g. in the same asset class, country/market, of similar risk profile and/or industry.
The central tenet is to choose a few massive winners instead of spreading oneself too far and losing ROI on underperforming assets. Well-founded in theory, in practice focused portfolios can be a bad idea. They carry increased risk – especially if assets with high correlation are picked.
Investors need to spend more time monitoring and managing their portfolio. In bear markets, investors may face worry, sleepless nights and in worst-case scenarios can suffer enormous loss of capital.
Is it better than to build a diversified portfolio instead? Be sure to check in for part 2 where we are going to introduce the concept of a diversified portfolio with all of its pros and cons!