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This Controversial Investment Strategy Should Be Understood by Every Investor

One of the most hackneyed mantras in the world of stock investing that is constantly pushed by financial advisors, stockbrokers, fund managers, and the financial media is diversify, diversify, diversify.

What many investors don’t realize is that investment banks, traders, and hedge funds are using a controversial strategy to make billions in profits that is the exact opposite of that mantra. The idea is that a concentrated stock portfolio of no more than 10-15 stocks can significantly outperform a widely diversified portfolio.

Let me explain. 

Now what?

Firstly, overly diversifying a stock portfolio reduces the potential gains.

Diversification reduces the specific risk that a single stock poses to a portfolio and prevents the failure of a single stock from having a cataclysmic impact on a portfolio.

Nevertheless, it doesn’t reduce market risk.

By investing in more stocks to diversify the portfolio, the greater the degree of market risk the investor has to accept.

It also leads to lower overall returns while increasing the likelihood of the portfolio being more adversely affected when the market falls.

Secondly, a concentrated portfolio enhances returns.

Research has shown that concentrated portfolios perform better than widely diversified stock portfolios. Famed economist John Maynard Keynes recognized this when he stated: “It is a mistake to think one limit’s one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

Even billionaire investors Warren Buffett and George Soros are adherent to the concept of concentrated investing.

Nonetheless, investors have to accept that the trade-off is an increased risk.

This makes it important to only invest in quality companies that are easy to understand and have transparent business models for the long term.

By investing in a concentrated portfolio, investors are also able to reduce the burden associated with researching the stocks in which they wish to invest. This makes it far easier to understand a particular company as well as identify those that are a good fit for the portfolio.

Finally, by holding a concentrated portfolio, investors can reduce transaction costs.

By trading more stocks, investors obviously incur greater transaction costs while increasing the overall burden associated with managing the portfolio.

In fact, research conducted at Australia’s University of Technology showed that large mutual funds as a group typically underperformed smaller funds because they experienced higher transaction costs. This highlights just how substantially transaction costs can impact the performance of a stock portfolio over the long term. 

So what?

The secret to holding a concentrated portfolio with a maximum of 10-15 stocks is the need to identify quality companies that possess wide economic moats, stable growing cash flows, and are incorrectly valued by the market.

One example of this is Alimentation Couche Tard (TSX:ATD.B), which Royal Bank of Canada listed among its top 30 global stock picks for 2017. Last year was a tough one for Alimentation because of natural disasters and unexpected business incidents.

Nonetheless, its core business remains solid.

It is also positioned to benefit from the enhanced business footprint and synergies offered by a range of acquisitions completed in 2016 which will drive higher earnings. Because of its extensive exposure to the U.S., it will benefit from Trump’s anticipated fiscal stimulus and the ongoing economic recovery south of the border. For these reasons, it is attractively valued and offers considerable potential.

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Fool contributor Matt Smith has no position in any stocks mentioned. Alimentation Couche Tard is a recommendation of Stock Advisor Canada.

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