Does everyone need diversification? Not always, at least not with the entire portfolio. Some money managers are downright evangelical about not diversifying too much. Here's the debate, with tips on concentrating portfolios safely.
Diversification and asset allocation are the accepted ways of spreading risk and protecting oneself.
Of course, these strategies can doom you to underperform the widely reported indexes. As a result, brokers often have clients who feel they need more growth potential than diversification provides, especially given the price they pay full-service firms.
For those willing to take the risk, concentrated accounts or funds - those that hold a limited number of stocks or concentrate only in certain sectors - may be an answer.
"Concentrated accounts are not for everyone," says Len Reinhart, who runs Lockwood Financial Group in Malvern, Pa., a managed account provider. A concentrated approach is "one of the options you want for an aggressive, wealth-accumulating investor," he says.
Reinhart defines a concentrated account as a portfolio invested in less than 12 stocks or three or fewer sectors. "If there are more than 12 stocks or more than three sectors, the portfolio will take on the characteristics of the market."
Likewise, PaineWebber investment strategist Mary Farrell, in her book "Beyond the Basics," contends that most of the benefits of diversification can be achieved from portfolios containing 12 to 18 stocks.
Waving the Flag Concentration has its proponents and even some evangelists. One is Bob Markman, president of Markman Capital Management in Minneapolis.
"Concentration is the only way to go," Markman says. "Any money manager brings diminishing returns after the first 10 picks."
He faults investors and brokers for clinging to diversification. "They prefer not being wrong," Markman says. "They'd rather be mediocre than risk being embarrassed once in a while."
Markman, who manages portfolios, lauds concentrated account strategies on his Web site www.markman.com. Beware: He is an outspoken critic of modern portfolio theory, warning investors about the "misguided and ineffective" asset allocation advice they may get from brokers and financial planners.
Markman argues that historical market data is inaccurate. He also claims that asset-class correlation measures have changed over time, and that using volatility as a gauge of risk is inappropriate.
To manage risk, Markman suggests using short-term bonds and cash, while keeping growth investments concentrated.
Jim Oelschlager, president of Oak Associates, a money management firm in Akron, Ohio, also prefers concentrated accounts, noting that an overdiversified portfolio limits the impact of good performance in one sector.
"How much return can you get if you're spread over 101 stocks?" Oelschlager asks. "Our objective is to outperform the market. You can clearly do that with 15 to 18 stocks."
Most investors don't get the most out of their assets, Oelschlager says, so they tweak their portfolios to beat the S&P. "Instead of managing their accounts, they become closet indexers."
Meeting the Need Not everyone needs to outperform the averages, of course. But there is a place for taking calculated risks. And some investors seem interested in focusing a few of their bets.
Merrill Lynch's Holdrs products, for example, have gained a following both with brokers and do-it-yourselfers, judging by lively chat forums devoted to the issues. The products give the investor actual ownership of a selected basket of stocks - similar to a sector fund.
Steve Bodurtha, head of Merrill's Customized Investments Group in New York, says Holdrs can be used for diversification as well as an "entry mechanism into a sectored account."
Concentrated mutual funds have also attracted assets. This past March, Merrill's Focus Twenty Fund was one of the top asset gatherers in the fund industry. The companies in the fund "represent our 20 best ideas," says fund manager James McCall in New York. "We'll then layer our next 30 ideas into Our Premier Growth fund for investors who want a little more diversification."
The Merrill fund is a copy of the hugely successful Janus 20 fund, which also holds 20 to 30 stocks, and makes big sector bets. As of this past June, for example, 40% of the portfolio was concentrated in five tech stocks - AOL, Cisco and Sun Microsystems among them. The fund's concentrated sector bets have produced 40%-plus average annual returns over five years and attracted $35 billion in assets.
Waiting to Catch On Despite the success of some sector products, concentrating a portfolio hasn't caught on in the managed account area, Reinhart says. Perhaps managers and consultants know better than to take the risks. Perhaps managed clients simply don't need to shoot for the stars.
Brian O'Toole, senior vice president of Assetmark Investment Services in Chicago, which provides fee-based management platforms to investment advisers, says most clients prefer general portfolio diversification because they want predictability, not uncertainty.
But advocates of concentrated accounts point to what they feel is poor relative performance of widely allocated portfolios.
"Diversification drugs your portfolio," Markman says. "It's like Michelangelo on Prozac - just blandness."
Mark Dick, an A.G. Edwards broker in Rochester, N.Y., thinks he's got a reasonable way to concentrate parts of his clients' accounts. He starts most investors off with basic growth-and-income funds and dividend-paying stocks.
Assuming clients aren't bored to tears for the several years it may take to build a conservative base, he begins looking for broad sectors (technology, financial services, health care) in which to concentrate a portion of their portfolios. Dick has clients dollar cost average an account's income stream into funds that will participate in these sectors.
Risk-taking - within limits - is worth it, Dick says. "Another baby boomer turns 50 years old every nine seconds, so that makes biotech and health care look attractive," he says. "But what if one of your concentrated sectors was [weighted with] Johnson & Johnson during the cyanide-in-Tylenol scare? What if you loaded up on a company that made fen-phen," the diet pills eventually banned by the FDA?
Dick's advice: "Do your homework and keep any one sector under 15% of the portfolio."
Mike Kicera, a broker at McDonald Investments in Rochester, N.Y., puts similar limits on his clients, but believes in concentration in general. He picks sectors with higher relative strength than the S&P 500 and bales to other sectors before the performance comes back in line with the S&P.
One way Kicera picks attractive new industries is by comparing 20-week and 50-week performance. He focuses on areas in which outperformance is accelerating.
"There is no set time to stay or leave," Kicera says. "But when your sector starts to falter, it's time to exit and concentrate elsewhere."