| Let’s look at the super-concentrated 1 stock portfolio first.
There is a 19% chance that your 1 stock portfolio returned an XIRR above 16%. But that comes with a risk – a huge 29% chance that your 1 stock portfolio would have returned an XIRR below -16% in the last 3 years. So yes you can make it big, but you can also get bowled out early.
A moderately diversified 15 stock portfolio, on the other hand, has a low 1% chance of achieving an XIRR of over 16% but also has a negligible almost 0% chance of achieving an XIRR of below -16%.
A more clear picture emerges if you think about the distribution of outcomes of a concentrated portfolio vs a diversified portfolio. The outcome of a concentrated portfolio is bar-belled. A high chance of riches and a high chance of going bust. It’s like the samurai code – you live by the sword and you die by the sword.
I am not sure if this translates to how most traders and brokers frame “concentration builds wealth” as that statement has a certainty to it that does not exist in the data. With concentration, you are taking a big bet. On average that bet will give outcomes worse than a diversified portfolio – it will clearly destroy wealth. We find that the average 3-year XIRR of a single stock portfolio is -3% while that for a 15 stock portfolio is 1.4%. For an index fund, the same is between 5-7% based on Nifty or Sensex indices.
The data is clear – concentration does not build wealth for the average investor with a concentrated portfolio. But for a few people, who will eventually get monickers like the big bull, that concentration will work and make them wealthy. Are you willing to take the risk of going bust to be one of them? If you answer no, then diversify. And when someone tells you ‘concentration builds wealth’ share this data with them. |
