Diversification is important. It’s a hedge against our inevitable mistakes and an uncertain future, and protects us against losing too much money–an amount that would impact our lifestyle, undo years of hard work and savings, or in the case of professional investors, cost us our job. But, how much is enough? And can you have too much of a good thing?

The average investor, though, likely only has the capacity to properly monitor up to 30 individual companies–especially if they have a day job that isn’t investing, children or other family members to care for, or any other hobbies or life challenges to occupy their time. The average investor also doesn’t have the same level of access to company management, nor a team of analysts, a Bloomberg terminal, institutional research reports, and IPO prospectus materials. It’s also worth noting that Lynch retired at the sprightly age of 46, such was the toll of his investing career.

Warren Buffett, on the other hand, is famous for his concentrated investing style that has generated incredible returns for Berkshire Hathaway shareholders over decades. Investors almost immediately associate Buffett’s name with the likes of Wells Fargo, Coca-Cola, American Express, and nowadays, Bank of America and Apple. Buffett has been quoted as saying: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

As well as being the most sophisticated and talented of investors, Buffett has a clear reason for his concentrated strategy. He wants to always allocate new funds to his best idea, and his best idea is usually something that he already owns (a lot of!). Although this is outdated given the bank’s subsequently-aired scandals, Berkshire’s vice-chairman Charlie Munger described this strategy succinctly: “Our best idea is Wells Fargo. And we would compare every stock that we’re looking at to Wells Fargo. If it’s not better than Wells Fargo, why not just buy more Wells Fargo?”

The success of these great performers will cause them to become an outsized portion of the portfolio at times, and diversification encourages people to sell. On the other side, poorly performing stocks will become so small that investors will be encouraged to add to these positions. As Frank E. Block wrote in “The Elements of Portfolio Construction” all the way back in 1969: “more often than not, both moves turn out to be mistakes.” Taken to the extreme, one good investment in Amazon in 1997 has turned Bill Miller from Miller Value Partners into a billionaire (he also credits his more recent Bitcoin purchases).

Adding an additional ETF to a portfolio may not provide any additional diversification benefit. Even with individual shares, an investor might think they are gaining diversification by increasing the number of companies. While this is true to a certain extent, if they are within the same industry or have other overlapping features (e.g., macroeconomic risks), the extra benefit may be minimal.

While the numbers may vary slightly, the theory in financial courses is remarkably consistent. Diversification provides enormous benefits starting from your initial investment until you build out a portfolio of at least 5, and preferably 10, (lowly-correlated) investments. The benefits of diversification begin to decline substantially after 15 stocks, and even more after 30.

 

These guidelines relate to both “volatility” and “risk”, which some investment professionals use interchangeably (a topic for another day). Block’s article described it as a “probability of success.”

Yet the future is an uncertain place. The unexpected can happen at any time, as we’ve seen in recent times from the pandemic, the outbreak of war in Ukraine, and the rapid change in interest rates and inflation.Concentration can have a dramatic impact if things go the wrong way. Ruane Cunniff & Goldfarb Inc.’s Sequoia Fund tarnished an incredible long-term track record by allocating up to 15% to the infamous Valeant Pharmaceuticals, damaging their reputation and causing conflict inside the firm.

This personal impact is often the most under-appreciated factor. While there’s no doubt that greater concentration can produce better returns (if executed well), it can still take its toll. Joel Greenblatt delivered a phenomenal 50% annualised return between 1985 and 1994 at Gotham Capital using a portfolio that generally held 6-8 investments. He acknowledged, however, that it often kept him up at night. As described above, Peter Lynch retired at just 46.

Ultimately, the best level of diversification will be what you’re comfortable with and allows you to make smart investment decisions that keep you invested, to reap the benefits that long-term share ownership can bring.