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Written by: John Drachman
In sharp contrast to our downbeat, COVID-haunted 2020, the S&P 500, NASDAQ and other indexes finished the year at cheerful new highs.
At those heady levels it’s natural to look at your traditional diversification strategy and wonder “why aren’t I having more fun?” Many others were – and still are. Take the investment gurus at Baron Capital for example: After Barron’s Magazine trumpeted “if Tesla’s rally continues, funds with large Tesla holdings will benefit the most,” fund management took a victory lap. Following major Tesla bets in two of their non-diversified portfolios, Baron Focused Growth Fund and Baron Partners Fund, they managed to outperform their benchmarks easily in 2020.
Baron Capital threw out a lot of “baskets” as they invested about 40% of their investors’ “eggs” in the world’s most valuable car company, Tesla, Inc. (NASDAQ: TSLA) which soared 743% in 2020 as it became the sixth most valuable U.S. public company just behind Apple, Microsoft, Amazon, Alphabet, and Facebook.
More eggs in fewer baskets
The temptation to place bigger bets on a short, concentrated list of growth companies can be compelling. But is it a good idea for you? “An investment strategy will only work for you if it meets your standards,” says U.S. News’ Paulina Likos. “The argument is not which strategy is better; rather which strategy works best for you.”
As timeless as the principal of diversification is, a more concentrated or thematic approach can be just right for participating in innovative new market segments – like Tesla’s combination of automobile manufacturing and digital technology.
Portfolio Manager Tom Vician put it this way: “A concentrated investing strategy has the potential to generate strong returns above the market.” It can also deliver sharp declines if the market turns against the company or market segment.
The case for concentration
Before taking a seat at the focus fund table, you’ll want to answer two questions:
- Are my financial goals defined well enough so I can confidently determine if a more concentrated approach is best for me?
- Do I have the fortitude to take on the higher level of risk that such a focused strategy will demand from me – and still manage to sleep at night?
Concentrated portfolios can capture more market returns than more diversified portfolios because a short list of innovative, industry-leading companies has the potential to supercharge upside performance – as long as the market is going with you. On the flip side, a concentrated portfolio can bite you if you pick the wrong companies or sectors. To guide your selections, the advice of a financial professional can prove invaluable. Besides helping to qualify your investment goals, a licensed advisor can provide guidelines for identifying those selections that have a better shot at outperformance – a complex task that requires a demanding combo of knowledge, discipline and expertise.
Next: Goodbye Diversification; Hello Focused Portfolio Part 2. The case for investing in the best of both worlds is explored. By tempering the impact from a short, concentrated list of sector winners with a complementary diversification strategy, alpha seekers can pursue the performance they want – while managing to get the sleep they need.
John Drachman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.