Let your portfolio concentrate for you.

The vast majority of financial literature will tell you to diversify...

There is another opinion that concentrating your portfolio only on your few highest performing positions can help dramatically your performance.

After all, it’s how Warren Buffet achieved a 21% compounded annualized return over his career.

In his 20’s, he put all his money into Geico. Recently, he added more and more to his position in Apple (AAPL).

Firm conviction can be the enemy of truth.

Even some of the best investors in the world have made mistakes, concentrating too much into only a few bets.

Imagine you decide to invest $120,000 today...

If you apply this approach,
you could invest it equally in at least 12 companies, resulting in 12 individual bets of $10,000, each representing at most 8% of your 'cost basis' (10,000/120,000).

If we return a year later, hypothetically, let’s say one of your investment is up 200%, two companies went bankrupt and all 9 other companies are unchanged.

Here is how your portfolio would look like:


From a cost-basis perspective, we have only allocated 8% of our investment to Company A… YET from a current value perspective, our portfolio is 25% allocated to company A.

Our portfolio has concentrated into company A simply because it is the “biggest winner,” the investment that has performed the best over time.

If we were to invest additional funds to that portfolio, it would be okay to add more to our position into company A as long as it remains no more than 8% of our new funds invested in the portfolio.

A cost perspective rather than a current value perspective gives us two big advantages:
1. Your winners will represent a larger part of your portfolio simply because they are winners, not because you took unnecessary risk.

2. It will prevent you from adding too much to your losers.

We are hard-wired to add to our losers in order to be break-even faster and sell our winners in order to secure our gains.

Ever felt like this?

That’s inherently a recipe for a losing performance because winners tend to keep on winning and losers to keep on losing.

I like to compare this to cutting your flowers and watering your weeds.

If you keep adding to Company L simply because it is down 50% and it “has to come back up at some point,” you might end up with a big loser that offset most of the performance of your winners.

If you keep selling your winners as soon as they reach, say 100% gain, they will never compound to a significant portion of your portfolio and you might miss on the single investment that would have driven your portfolio performance for the years to come.

Outliers, massive ‘multibaggers’ like Amazon or Netflix (NFLX), are the very companies that are allowing the S&P 500 to grow at a 10% annual return. They more than offset the other companies that perform far under the average.

If you don’t let the few investments in your portfolio that are overperforming take a bigger piece of your portfolio over time, you will be left with average performers and a bunch of losers slowly overtaking the portfolio allocation.

If your top 3 investments become more than 50% of your portfolio,
they got there themselves.

Not because you blindly invested in them in an unreasonable way.

Keep track of your cost-basis and try to maintain the cost allocation of every single individual stock in your portfolio below 8% as a rule of thumb.

As the great AEI put it amicably,

Let the current concentration of your portfolio be a result of its sheer performance, not a result of your firm convictions.