Many personalized factors feed into the debate between concentrated versus diversified portfolios. The argument is not which strategy is better , rather which strategy works best for you.

To determine whether you are a diversified or a concentrated candidate, investors need to be real with the answers to the following questions: What are my financial goals, and, most importantly, how much risk am I willing to take?

Diversification is a well-known and practiced investment strategy, but other strategies, such as the concentrated approach, may be more appropriate for different market segments.

"A concentrated investing strategy has the potential to generate strong returns above the market or sharp returns below the market," says Tom Vician, an independent portfolio manager with SHC Financial in Bellevue, Washington. "The question is how much risk are you willing to take."

The market will always generate winners and losers. Investors can take a multitude of approaches as they search for the diamond in the rough, but choosing the appropriate investments and implementation strategy that aligns with your risk tolerance is part of the battle. Here are a few things to consider when deciding on your investment strategy:

Know the difference between diversified and concentrated.

Understand the pros and cons of each strategy.

Learn how each strategy works.

Evaluate what sectors are better suited for each strategy.

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Differences Between Diversified and Concentrated

Diversification in your portfolio can be an important investment strategy; it's a technique that helps curtail volatility in your investment options .

"Stocks in the same sector are going to move similarly and have a high degree of correlation, but companies in different sectors, driven by a variety of external factors, have low degrees of correlation – this is what diversification means," says George Calhoun, professor of quantitative finance at Stevens Institute of Technology in New Jersey.

It's well-documented in the wealth management world that strategically allocating your investments in multiple securities, sectors and categories can grow your returns while safeguarding your overall portfolio .

There is no guarantee, however, that diversification will increase your portfolio's performance or protect against a loss of profits. Instead, the diversified investment strategy is a stabilizer between different asset classes.

Diversification is not concerned with individual stock performance but with the overall performance of the portfolio.

"If you have 20 stocks that have 20% volatility each, if these 20 individual stocks are not correlated in a portfolio, the overall portfolio only has 3% volatility," Calhoun says.

A concentrated portfolio strategy involves purchasing a small number of quality stocks . The idea is, the more concentrated an investor is in their equity position, the closer they are to reaching or surpassing broader market performance.

The key to success for a concentrated portfolio is for investors to be intimately aware of the companies they invest in.

"Concentration portfolios don't care about correlation but about the quality of the companies. Investors load up on those with a small number of positions that they can really stay on top of," Calhoun says.

With a focus on fewer companies, investors must dedicate time to analyze each business. Educating yourself on companies under this approach can direct investors toward better investment decisions – whether to hold, sell or increase your position.

Vician stresses it takes a certain personality to accept the level of volatility associated with the concentrated strategy, which is much larger than the general market.

"Most people can't take the risk to suffer a massive drawdown. Compared to someone who is invested in the S&P 500, a smaller number of investors are willing and able to take on the concentrated approach," Vician says.

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Taking the Diversified Approach

Most people can stick with diversified investing since it's a well-balanced, long-term approach. Rather than having all assets concentrated under one investment vehicle, a pro for diversification is spreading risk among different asset classes.

"A diversified portfolio made up of the S&P 500, bonds and cash may have drawdowns with lower levels of volatility. This is the key to riding through market ups and downs," Vician says.

Applying a diversified approach also gives investors a chance to explore different sectors and industries on a global scale. This can include tapping into the emerging market economy when the domestic market is not performing well.

Even though diversification aims to reduce volatility and preserve wealth, it can have unintended consequences. Overdiversification of investments could put a drag on returns and limit the portfolio's potential profits with below-average results.

Another problem is diversification is less helpful in a market downturn, Calhoun says.

"With diversification, correlations between the different stocks might be low, but those correlations are not fixed and stable; they can change. When the market has a meltdown, all the correlations go up regardless of their noncorrelation, which means you lose the diversification benefit in a time when you particularly need it."

Since there are many investments in a diversified portfolio, investors must constantly monitor to rebalance the portfolio and maintain the proper level of diversification. This added layer of tracking each company's performance and making sure assets are allocated efficiently can be difficult, time-consuming and stressful.

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Navigating the Concentrated Strategy

Investors with a concentrated strategy have the potential to generate portfolio gains greater than general market averages.

With a focus on fewer but high-quality companies, concentrated portfolios allow the investor the opportunity to become very familiar with their holdings, managing them more productively and energetically.

Concentrated portfolios can capture more market returns than broadly diversified portfolios because there are stronger equity positions in durable, industry-leading companies, increasing the probability of better portfolio performance.

On the flip side, a concentrated portfolio can suffer if investors don't pick the right companies. Investors must exhibit the ability to choose a stock that has the potential for long-term sustainability – only by having a strict set of guidelines when selecting stocks can you attempt to beat the market, a process that takes time and dedication.

"The concentrated approach requires the investor to be nimble and to commit to this strategy for the long term, not just for one bull market cycle," Vician says.

A concentrated strategy may have more potential for capital gains, but it's more difficult to implement a concentrated portfolio successfully. Competing in this space demands more resources like capital, market research and access, says Shrina Kurani, vice president of business at Republic, a startup investing platform in New York City.

"When you pick winners, you need to have resources at your disposal such as capital to prevent your stakes from being diluted, market expertise for due diligence and access to get in early at a good valuation."

Another important tip for concentrated investing: Invest in what you know.

"If you're going to put a lot of money in a concentrated approach, you want to be an expert in the space or have a network with sector expertise. You have to understand your investments much more than a diversified approach," Kurani says.

What Sectors Are Better Suited for Each Strategy?

In a concentrated portfolio, market capitalization doesn't matter. Typically, technology has been a popular sector since it develops new products that everyone uses.

The diversified passive model is best suited in a sector with low dispersion. For example, in a sector like energy or utilities, all of those companies are well-correlated, says Calhoun, "Chevron (ticker: CVX ) and Exxon ( XOM ) track each other, and their performance looks very similar over long periods of time because they're both being influenced by the price of oil. This is called dispersion: Companies that track each other are said to have lower dispersion because it's difficult to pick which one will be the loser or winner in the sector."

In this case, Calhoun says investors could buy a diversified exchange-traded fund and not worry about the outperformance of either company because they're probably going to perform similarly.

Conversely, in a sector with high dispersions, investors want to try to separate the winners from the losers. For example, in the health care industry, pharmaceutical companies like AstraZeneca ( AZN ), Moderna ( MRNA ) and Gilead Sciences ( GILD ) competing to develop a vaccine for the coronavirus have a wide dispersion of outcomes.

"In this market, you want to try to pick winners that attract the concentrated philosophy because there's going to be a big difference between a company that develops a vaccine and one that doesn't. Study each company and their approaches to each vaccine. This is where the concentrated approach is needed," Calhoun says.

In the technology industry, there are specific aspects to look at for how the winner will emerge, says Michael Loukas, principal and CEO of TrueMark Investments in Rosemont, Illinois.

When a company experiences early adopters in the tech space, they are the first mover in the industry, and as a result, the ecosystem grows around that company, says Loukas.

The way to find first movers is more qualitative than quantitative. The small group of potential winners will start to emerge long before a company goes public. In the tech space, you need to have an eye on what's in the pipeline.

In the tech space, if you're concentrated, you need to start from a qualitative perspective before a company is public with client adoption being a good indicator, Loukas says.

"When a company is private, there isn't empirical data to analyze, so a lot of the assessment is qualitative. The biggest factor to identify players is understanding client adoption and customer satisfaction. This momentum will continue to increase into the public market."

Takeaway

There are many rules to stay on top of to achieve your specific goals in either the diversified and concentrated strategies. It's not easy identifying winners and losers or maintaining a well-balanced portfolio, but it gets easier when investors stay true to their financial goals and risk tolerance.

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