The Sequoia Fund, managed by proteges of Warren Buffett, highlights the risks of focusing on just a few stocks. Although it has one of the best long-term records of any actively managed mutual fund, two of its directors recently retired because a big bet on just one stock, Valent Pharaceuticals, turned out poorly.
The tradition of an “under-diversified” portfolio, however, includes some big wins. Benjamin Graham’s investment in Geico in the mid-1970s is an example. Warren Buffett has defended the approach as appropriate for “know something” investors, whereas “know nothing” investors should have widely diversified portfolios. Academic work supports the assertion that less-diversified mutual funds had better performance, on average, than the most diversified actively managed funds.
However, as Mark Hulbert points out in reporting on this topic for Marketwatch, “it’s human nature for each of us to think we’re above average.” Thus, he suggests, “our default assumption should be that we don’t know how to pick stocks, and that therefore we should invest in an index fund.” Nonetheless, “it would be going too far to conclude that no one has stock-picking abilities.”