Danger Zone! Understanding the Perils of a Concentrated Portfolio

Investing legend Stanley Druckenmiller once said, “The greatest investors make large, concentrated bets where they have a lot of conviction.”  Some of the world’s wealthiest people have staked their entire net worth on an idea (an internet book store), a stock (Tesla), or even a contrarian viewpoint (betting against mortgage-backed securities).  But to develop a conviction so deep that you’re willing to stake your life’s work takes an extraordinary amount of time, expertise, and guts.  Most investors can’t afford to take on that kind of “swing-for-the-fences” risk.

Druckenmiller has said that concentrated bets require paying close attention and that you need to watch the basket carefully—if you are putting all your eggs in said basket.  If you are not able to do proper due diligence on an investment, have a thorough understanding of the markets, and withstand stomach-churning drawdowns, you are merely speculating, which can mean disastrous outcomes for your portfolio.

Even the greatest investors can fall victim to their fear of missing out (or FOMO, as the kids call it).  After making billions of dollars in 1999, at the height of the Dotcom Bubble, Druckenmiller believed the market was near the top and sold everything.  But after watching his peers continue to make more, he bought back his shares in 2000.  He lost $3 billion dollars on that single trade.

Most of us don’t have that kind of money to gamble and are instead working toward steady returns over the long term. A better game plan, at least for the vast majority of retail investors, is to pick a diverse “basket” of assets, ignore the market’s ups and downs, and let rebalancing take care of the rest.  Let’s look at why.

Concentration Equals Risk

Assume three investors all start with $100,000 just before a market correction. 

The first investor has gone all-in on the Game Stop meme craze near the top, only to watch 75% of their investment vanish (and not recover). The second investor has a slightly more diversified portfolio of 10 assets and loses 50% of their portfolio balance. The third investor has a strong allocation of roughly 100 assets and takes a 25% loss.

Then, after the fall, let’s say each investor reinvests their resulting balance in a portfolio that achieves either 12%, 9%, or 6% returns, relative to their initial risk level, until the principal balance is recovered.  

Did you know that it would take more than double the time for the concentrated portfolio to recover versus the most diversified portfolio? The former would take nearly 12 years to recover, which we all know is an enormous amount of time in the investing world. 

 Correction ValueRecovery Rate (Monthly Compounding)Years to Recover Original Principal
1 asset that loses 75% of value$25,00012%11.75
10 assets that lose 50% of value$50,0009%7.8
100 assets that lose 25% of value$75,0006%4.9

In the past, I’ve lost more than I’ve gained on individual stock investments.  Even though I believed I was doing comprehensive research, following the financial reports, and timing the market, I swung and missed.  In reality, I still had a day job and not enough time to conduct a deep analysis to make appropriate decisions.  But in contrast, my diversified portfolio has far outperformed any of my individual stock picks over the long term, with less risk and much less active participation on my part.   

Diversification Reduces Risk

While it’s impossible to create a portfolio that reduces all risk, you can weather market storms by intentionally diversifying across multiple assets, investment sponsors, markets, and sectors that are not necessarily all affected in the same way by unpredictable market events. At Cira Capital Group, we use the Fund of Funds vehicle to diversify in private equity real estate across all factors listed above. 

By spreading your investments over many assets with low or no correlation, the chances of a huge loss like in the above example are slim. Even a portfolio that earns lower returns will, over time, outperform a portfolio that suffers large losses due to an unlucky or uneducated investment in just one or two assets. 

The Bottom Line

Unless you are a full-time investor with lots of experience, time, and a rock-solid thesis, you’re probably not going to win at the concentration game. Most investors are better suited for a diversification strategy that focuses on long-term growth without gut-wrenching stress.

At Cira Capital Group, we help busy professionals diversify their traditional investment portfolios by creating funds, pooling investors’ capital with our own, and investing in commercial real estate with world-class operators.

Interested in learning more about our investments?