The Dark Side of Portfolio Concentration

Such an approach would also yield a rather expensive diversified portfolio. Most concentrated funds levy hefty front-end loads and sport higher management fees than diversified offerings.

There are no doubt a plethora of readers wondering where Warren Buffett fits into this argument. The Oracle of Omaha is legendary for both his stunning long-term performance and his predilection for amassing large holdings of just a few stocks. "We are reminded that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin," he says in The Essays of Warren Buffett (John Wiley, 2001). That may be, but one should note that according to the latest Berkshire Hathaway shareholders' meeting, about 38% of the firm's assets are dedicated to fixed income trading. Sounds like diversification to me.

My response to the concentrated portfolio issue is simple. RIAs should strive not to maximize return, but to create a process where gains are possible, if not probable, in a vast majority of market conditions. With that, consider the mighty 60-40 stock-bond blend. Not only does it trounce concentrated fund returns over the long haul, it does so with far less risk.

Do concentrated funds have a place in a well-constructed portfolio? Perhaps, but I wouldn't consider one unless that manager has a good track record and the ability to go short (like in a hedge fund), which serves to reduce beta during difficult market conditions.