Are concentrated portfolios effective, and if so, what are the risks?

Over time, most concentrated portfolios perform worse than diversified ones

Terry Tanaka advises investors to exercise caution when assuming that a strong run will continue.

Among the most renowned British fund managers are Nick Train, Terry Smith, James Anderson, and Harry Nimmo. By using concentrated portfolios and a high-conviction investing strategy, all four achieved exceptional records in their respective fields.

"Concentrated" can mean different things. Perhaps 20 larger stocks. If you're looking at riskier small caps, it might reach 50. It might be an excessive emphasis on a specific industry. In any case, there are many managers and funds that have outperformed by selecting the correct basket of companies, but it's not for the timid.

The most well-known investor of all time, Warren Buffett, has long maintained that it only takes a small number of "wonderful companies" to outperform the market over the long run, even though he has also stated that the majority of people should just purchase index funds.

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Hedge funds employ concentrated portfolios.

Many of the top hedge fund managers have very concentrated portfolios. Public filings show that Chris Hohn's £50 billion TCI Fund Management has less than ten stocks. Approximately 20% of the disclosed portfolio is made up of Visa. The London-listed investment trust of the same name is owned by Bill Ackman's hedge fund, Pershing sq\. Capital Management, which has only eleven holdings. Despite not being a hedge fund, the Bill and Melinda Gates Foundation Trust is extremely concentrated, with five holdings holding 80% of its equity assets.

This may lead to remarkable returns. Over a ten-year period, London-listed Pershing sq\. (LSE: PSH) has produced an annualized net asset value (NAV) return of 325 percent, or 14 percent. Other top performers include 3i (LSE: III), whose portfolio is dominated by activist UK small-cap trust Rockwood Strategic (LSE: RKW) with a total of 25 holdings and European discount retailer Action. Even though they own more stocks, high-flying sector trusts like Polar Capital Technology (LSE: PCT) are also effectively highly concentrated.

However, we also witness a lot of concentrated portfolio failures. Consider Train's Finsbury Growth Trust (LSE: FGT), whose top ten holdings comprise 85 percent of NAV. Since Train's quality-growth approach lost favor, this has had a very bad five years. Additionally, Smith's Fundsmith Equity has been extremely poor. Although it has since improved, Scottish Mortgage (LSE: SMT), which was formerly led by Anderson, had a very difficult 2022 due to its high-conviction growth strategy.

Results from concentrated portfolios may not be consistent.

According to financial data provider Morningstar, concentrated portfolios are generally unreliable. It assessed the "portfolio boldness and diversification by integrating stock, sector, and return-based factors" of 5,800 European-domiciled equity funds between 2015 and 2025.

"Concentrated funds have a substantially wider spread of outcomes, with fatter tails on both sides" and "on average, there is little to no meaningful relationship between concentration and returns" were the findings. To put it another way, concentration can result in "similar or greater frequency" of underperformance as well as outperformance. Additionally, there is a "higher probability of severe losses". Additionally, the cost of highly concentrated funds is higher than that of diversified funds and significantly higher than that of passive funds, which further reduced returns.

In the end, Morningstar discovered that during the ten years leading up to the end of 2025, low-concentration portfolios performed better than all high-concentration portfolios in every category. While the difference was negligible in emerging markets, it "amounts to approximately one-tenth of total ten-year returns, which is financially meaningful" in the US and global sectors. In summary, it is uncommon for managers to consistently outperform with a high-conviction portfolio. Investors should therefore exercise caution when assuming that a hot streak will last.