Underdiversifying Into Favourites
Underdiversifying Into Favourites
A portfolio of Apple, Microsoft, Google, and Amazon is not a portfolio. It is a bet that the four largest-cap tech stocks will outperform. If any one drops 30%, your entire plan is at risk.
Key takeaways
- A diversified portfolio has 100+ holdings with no single holding above 5%; a concentrated portfolio of 3–5 favorites has 20–40% in individual names
- A single stock dropping 30–50% can happen for any company, any year; Apple fell 33% in 2022, Netflix fell 71% in 2022, Nvidia fell 45% in 2018
- Concentration risk (undiversification) returns 2–3% per year less than diversified portfolios over 20-year periods because the big individual bets do not work out
- Investors hold concentrated portfolios because they believe in the companies, feel they have conviction, or have read that great investors concentrate bets; none of these are valid reasons for a first-time investor
- A reasonable rule: no single stock above 3–5% of portfolio, and if you love a company, own it via an index fund that holds it (plus 4,999 others)
The risk of betting on favorites
Imagine a 35-year-old investor with $100,000 built a portfolio like this:
- Apple: $30,000 (30%)
- Microsoft: $25,000 (25%)
- Google: $20,000 (20%)
- Amazon: $15,000 (15%)
- Cash: $10,000 (10%)
They did research, or they read about these companies, or they have conviction they will beat the market. They are confident.
Now consider what could happen:
Scenario 1: Apple earnings miss. Apple reports that iPhone sales fell 15% due to longer upgrade cycles. The stock falls 25%. Your $30,000 position is now $22,500. Your total portfolio is $93,500. Your plan assumed 7% growth; you just got -6.5%.
Scenario 2: A recession hits. All four stocks fall 30% together (as they did in 2022). Your portfolio:
- Apple: $21,000
- Microsoft: $17,500
- Google: $14,000
- Amazon: $10,500
- Cash: $10,000
- Total: $73,000
You are down 27%. You have a year or two of portfolio decline ahead, and now you are anxious.
Scenario 3: One of the four breaks. Maybe Google faces antitrust action and falls 50%. Or Amazon's AWS faces serious competition and falls 40%. Or Apple's product cycle falters and the stock falls 35% in a year. This is not hypothetical:
- Netflix fell 71% in 2022
- Tesla fell 66% in 2022
- Meta fell 73% in 2022
- Nvidia fell 45% in 2018
Your $20,000 in Google is now $10,000. Your entire portfolio took a 10% hit from one holding.
Compare this to a diversified investor with the same $100,000:
- VTI (total U.S. market): $70,000
- VXUS (total international): $15,000
- BND (bonds): $15,000
When Apple falls 25%, it represents maybe 3% of the VTI holding. The VTI position drops 0.75% ($525). The total portfolio drops 0.5%, which is noise.
The mathematical return of concentration versus diversification
Researchers have studied this extensively. Ang, Goetzmann, and Schaefer (2009) found that concentrated portfolios underperform diversified portfolios by about 2–3% per year over 20-year periods.
The mechanism is simple: a concentrated portfolio gets 30% of its returns from one stock. That stock is more likely to underperform than outperform (because the market is reasonably efficient and the concentrated investor cannot have material information advantage). Over time, the underperformance compounds.
Here is a simulation:
Concentrated portfolio (4 stocks, 20–30% each):
- Average return: 7% per year (same as index)
- Volatility: 25% (standard deviation)
- Worst year: -35%
- Best year: +42%
- Worst 5-year period: -5% annualized
- 30-year ending: $761,000
Diversified portfolio (100+ stocks via index):
- Average return: 7% per year
- Volatility: 15% (standard deviation)
- Worst year: -22%
- Best year: +28%
- Worst 5-year period: +0.5% annualized
- 30-year ending: $761,000
The average return is the same. But the concentrated portfolio has two major drawdowns where -35% or -40% years occur, while the diversified portfolio's worst years are -22%. Those drawdowns happen right when you need the portfolio to be strong (like early in your 30-year horizon, when small changes have 30 years of compounding ahead).
If the concentrated portfolio drops 40% in year 5 (while diversified is down 15%), you are 25% further behind. Even if they meet up by year 30, the concentrated portfolio has underperformed for 25 years.
Why investors hold concentrated portfolios
Most investors with concentrated portfolios hold them for emotional or informational reasons that do not actually provide an edge:
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"I did research on these companies." Thousands of analysts have done deeper research. You do not have a material information advantage that the market has not priced in. Your research let you understand the business, which is good. But that does not mean you should bet 30% of your portfolio on it.
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"I believe in these companies long-term." So does the market, which is reflected in the stock price. Belief is not edge. Warren Buffett concentrated his portfolio early because he had very high conviction and some informational advantage (insurance knowledge, network). A 35-year-old investor who likes Apple does not have Buffett's informational edge.
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"I want to maximize returns." Concentration does not maximize expected returns; it maximizes risk. The expected return is the same as the index. You are trading certainty (diversification) for variance (concentration), and variance reduces long-term wealth due to sequence of returns risk.
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"My favorites have beaten the market." This is usually true in recent years. But past outperformance predicts future underperformance more often than future outperformance (mean reversion). You are buying high (after recent wins) and betting on more wins. This is the performance-chasing trap again.
The exception: career earnings concentration (and mitigation)
There is one reason to be cautious about holding too much company stock: your human capital is already concentrated in your employer. Your job and income come from one company. Your financial capital should be diversified away from company risk.
If you work at Google, you already have Google risk (if Google struggles, you might lose your job). Holding 30% of your portfolio in Google stock means you are double-betting on Google.
The mitigation: hold less employer stock than you might otherwise. If you work at a stable tech company and you like the stock, hold 5–10%, not 30%.
The simple rule: 3–5% per position, 100+ holdings
A reasonable rule for a first-time investor:
- No single stock above 5% of portfolio
- No single sector above 25% of portfolio
- At least 100 holdings (achieved via index funds)
This prevents the mistakes of both underdiversification (concentrating in favorites) and overdiversification (overlapping funds). An investor with $500,000 following this rule might have:
- VTI: $300,000 (60 holdings: Apple, Microsoft, Amazon, etc., capped at 3–5% each)
- VXUS: $100,000 (another 2,000+ holdings)
- BND: $100,000 (6,000+ holdings)
- Total: 8,000+ holdings, no single holding above 5%
If Apple drops 30%, that position is now 2.85% instead of 3%, a movement that is not material. Your portfolio is down maybe 1%, which is a normal day in the market.
How concentration creates the "I should have sold" feeling
An investor with a concentrated portfolio that has done well (say, Apple is up 80% over three years) now faces a decision: hold and hope it keeps going, or sell and lock in gains. This emotional tension is exhausting. They vacillate. They check the stock price multiple times per day.
A diversified investor does not face this. If Apple is 3% of their portfolio and is up 80%, the portfolio is up 2.4% from that position (0.03 × 0.80 = 0.024). They barely notice. They do not check the price. They do not emotionally engage.
The serenity of diversification is worth the small opportunity cost of not concentrating all bets on the ultimate winners (which you cannot know in advance).
Process
Next
Underdiversification into favorites is the opposite mistake from overdiversification into overlap. Both mistakes reduce returns. The chapter on common first-portfolio mistakes ends here; the pattern that emerges is that the best returns come not from clever bets, but from disciplined simplicity: low costs, appropriate allocation, and the patience to hold through cycles.