In a world of increased uncertainty, many investors’ natural instinct is to “hedge their bets” by diversifying, rather than investing in a concentrated strategy. But this year, a portfolio consisting of just the five largest US stocks would have significantly outperformed. So, is there a way to reduce risk and to capture long-term growth in a concentrated portfolio?

Investors often choose to diversify extensively by investing in an ETF that replicates the benchmark. While this approach will provide market or ”beta” returns, it offers no opportunity for outperformance or “alpha”. But in a world where many companies are no longer offering guidance regarding their businesses because of COVID-19, we believe investors can seek better returns through active management based on rigorous fundamental analysis, particularly by focusing on companies that should be able to prosper even in these difficult conditions. Meanwhile, a portfolio consisting of just Microsoft, Amazon, Facebook, Alphabet and Apple would have significantly outperformed the MSCI World this year.

The Diversification Dilemma

So, is a five-stock portfolio the right approach? Well, in the unprecedented conditions created by global economic lockdowns, this combination performed extremely well. But on any longer-term timescale, academic research suggests somewhere between 20 and 35 stocks is optimal. In a global equity portfolio, most diversification benefits are achieved with 20 stocks (Display). Once the portfolio holds more than 35 stocks, further diversification benefits are modest. Of course, there may be other reasons to own more stocks, such as liquidity constraints or country and currency diversification, but additional individual stock diversification is not very beneficial, in our view.

Concentrated Portfolios Benefit from Persistent Growth Stocks

In our opinion, for long-term investing, stability of earnings growth is the key to success. We believe companies that can grow their earnings per share by more than 10% a year over three to five years are excellent candidates. According to our research*, from 1989 to 2019, global companies that delivered such consistent earnings growth over three years outperformed the market by 2.2% a year on average; those that did it for five years delivered excess returns of 3.5% a year.

These companies are also hard to find. Over the last 30 years, only 64 global companies on average managed to deliver 10% growth per annum over three years, while only 13 did so over five years. Holding a small number of companies like these in a concentrated portfolio can produce powerful results, in our view.