Concentration In Stock Picking
I just finished reading "The Intelligent Investor" by Bejamin Graham a few days ago. It was a good read, although I can't say I learned much I didn't already know. I'd already come around to the understanding that a declining market actually reduces risk, since you are buying companies more cheaply, while an increase in the market actually makes companies more pricey. A bit counter intuitive, but quite true when you get right down to it. I also already knew that I was not willing to invest the time and effort required to pick individual stocks and not do a shoddy job of it, hence why I invest in mutual funds.
Anyway, I digress. One thing that struck me that applies to this conversation is a section at the end of the book that was written by Warren Buffet (it was from some talk he had given). In it he discusses how the disciples of Benjamin Graham's value investing philosophy did after Graham had retired.
The interesting thing was that each of these disciples (Warren Buffet, Walter Schloss, and the guys who founded Tweedy Browne) had quite different ways of investing. Some followed a concentrated approach (Buffet), while others held around one hundred or more stocks (Schloss, Tweedy Browne), yet all did quite well. Some other examples were discussed as well.
Putting it briefly, I think it is wrong to assume that concentration in stock investment necessarily means better performance. I believe it depends on the specific fund manager and their inclination.
Another point is I do not feel that Graham was an advocate of extreme concentration. His viewpoint seems to be that on average value investing techniques work, but there is always some degree of uncertainty, or chance involved. By diversifying you are limiting the impact of chance on your results, and thus leveraging the advantage that value investing techniques give you.
I believe this is a strong argument against extreme concentration, because just because an individual stock pick is your "best idea", doesn't mean it cannot prove to be wrong, possibly for no fault of your own. For example, was Bill Nygren wrong about his investment in Washington Mutual, or just unlucky? Chance can cut both ways.
Diversification provides protection against random acts of chance, or if you prefer, unforeseeable conditions, that can arise and crush even your "best ideas".
(Please note that this does not rule out concentrated funds, see the fund section below, but it does argue against holding only a single concentrated fund.)
Concentration In Regards To Mutual Funds
That said, there is a major difference between individual stocks and mutual funds. That difference is the fact that a mutual fund, even a concentrated one, is already fairly diversified. There is no need to spread your money around between a dozen managers for diversification purposes, because you'll already have that by owning as few as one or two funds (assuming that each fund is not super concentrated). Even if your funds are all highly concentrated (20 holdings or so), you'll achieve adequate diversification with four or five funds.
When it comes to choosing funds I feel there is only a select group of managers who are really worth investing in. Which of them will perform the best going forward? I don't know for sure, but I don't think it hurts to try to pare the list down to the point where you end up with a few of the most favorable conditions.
Which mutual fund performs the absolute best is probably determined by chance as much as skill, but chance is unpredictable so it can't be used as a criteria. We're left to focus on those traits which are readily identifiable which can indicate a fund has a chance of performing better. Since a "great fund" by this sort of measurement has just as much chance of also benefiting from chance as a merely "good fund", I see no reason not to stick with the "best".
