Why You Should Run a Concentrated Portfolio

If you're researching and investing in individual stocks on the stock market, you should run a concentrated portfolio to outperform the overall market.

This may be contrary to what's taught by most financial advisors, but the reality is that a handful of exceptional businesses drive the overwhelming majority of market returns over time.

Despite interim volatility and periodic underperformance, investors who focus capital on the highest-quality businesses produce astounding results over the long term. This happens because they avoid the dilution that comes from owning hundreds of mediocre companies.

The key is understanding what actually drives returns and structuring your portfolio accordingly.

Frequency Versus Magnitude

The concentrated approach flips traditional thinking about winning percentages.

A long-running concentrated strategy might outperform the market only half the time on a monthly basis and 60% of the time quarterly. Even on an annual basis, it might outperform just 70% of the time.

While 70% sounds respectable, what matters more is the size of your gains versus your losses. A portfolio that wins 70% of the time but generates small gains and large losses will underperform one that wins 50% of the time but produces massive gains when right and modest losses when wrong.

Hendrik Bessembinder's research, "Do Stocks Outperform Treasury Bills?" (2018), analyzed U.S. stocks from 1926 to 2016 and found that just 4% of all stocks accounted for the entire net gain of the stock market over that 90-year period. Additionally, more than half of individual stocks failed to beat returns from one-month Treasury bills.

The takeaway is that most stocks generate mediocre or negative returns. Although identifying exceptional businesses is difficult, holding a concentrated portfolio long term ensures you capture the full compounding benefit when you successfully identify one of those rare winners.

Position Sizing Rules

Running a concentrated portfolio requires knowing what stocks to avoid, when to let winners run, and how many positions to hold.

Categories of Stocks to Avoid

For a concentrated portfolio, you should generally avoid several categories of stocks that increase tail risk:

• Highly leveraged businesses: Banks and similar institutions should typically be excluded. The combination of high leverage and concentration creates unacceptable risk. Securities with embedded leverage fall into the same category.
• Very cyclical businesses: Their earnings fluctuate dramatically with economic cycles, making it difficult to assess intrinsic value and creating substantial drawdown risk during downturns.
• Capital-dependent entities: Businesses that require constant access to capital markets, such as certain REITs, increase risk unnecessarily. These companies depend on external financing to grow, which can disappear during market stress.

Avoiding these categories reduces the risk of permanent capital loss in a concentrated portfolio.

Related: Why Not Bank Stocks?

Don't Sell Your Winners

While having self-imposed limits to position sizing is advisable for prudent risk management, you should let your winners run.

Warren Buffett once quoted Peter Lynch's advice from "One Up on Wall Street":

"When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds."

— Warren Buffett, 1988 Berkshire Hathaway Annual Shareholders Letter

Selling outperforming positions removes the stocks generating your highest returns, which is what drives superior long-term performance in a concentrated portfolio.

Related: 12 Reasons to Sell a Stock

How Many Holdings Should You Have?

To provide some guidance, with 5 stocks, concentration becomes substantial and each holding carries enormous weight. With 10-15 holdings, you achieve meaningful concentration while maintaining some diversification.

However, with 30 to 50 stocks, tracking each business properly becomes increasingly difficult. Each position also represents capital that could have been allocated to your highest-conviction ideas.

The benefits of diversification also diminish around this point. Diversification reduces unsystematic risk (company-specific risk) but cannot eliminate systematic risk (market-wide risk):

Edwin J. Elton and Martin J. Gruber's "Modern Portfolio Theory and Investment Analysis" (2014) found that most of the risk reduction from diversification happens in the first 20 stocks.

According to the authors, a single stock carries 49.2% risk (measured by standard deviation), but holding 20 stocks reduces that to 22%. Adding more stocks beyond 20, even up to 1,000, only reduces risk by another 2.5%. The first 20 stocks eliminated 27.5% of the risk, while the next 980 stocks barely moved the needle.

Business Owner Mindset

Investors who best understand concentrated, long-term investing are often business owners themselves. They focus on cash generation rather than short-term stock price movements, evaluate reinvestment opportunities based on returns on capital, and assess whether management allocates resources wisely over multi-year periods.

The business owner doesn't check valuations daily or worry about quarterly underperformance. They think about whether the underlying economics are improving and whether the business will be worth substantially more in 10+ years.

For individual investors, adopting this mindset means defining acceptable returns tailored to personal goals rather than simply buying the market index. This approach requires patience, discipline, and comfort with being different from the market. Your portfolio will look nothing like broad indices and will underperform during certain market environments.

The reward for accepting these challenges is the potential for superior long-term returns generated by focusing capital on the highest-quality compounders.