Concentration and Diversification
Diversification lowers the variability of an outcome and lowers the extremes in both directions. Which is preferable is a question about objectives rather than about markets.
MadStockAlerts Research · Updated August 29, 2026
What to take away
- Diversification reduces the variance of outcomes, not the expected return.
- Most of the benefit arrives within the first fifteen or twenty distinct positions.
- Concentration raises the range of outcomes in both directions.
- Individual stock returns are highly skewed, which is an argument on both sides.
- Position count is a poor proxy for diversification; distinct exposures is a better one.
MAD Academy Training Video · 0:44
Concentration Builds It, Diversification Keeps It
Concentration and diversification answer different questions, and the right answer changes with how much you already have.
This lesson is part of a Stock Alerts + Tools plan.
What diversification does
Adding imperfectly correlated positions reduces the variability of the portfolio's return without reducing its expected return. That is the closest thing to a free lunch in this subject and it is also frequently overstated.
- It removes security-specific risk, which is the risk of any individual company doing badly for its own reasons.
- It does not remove market risk, which affects everything at once and is what remains after diversifying.
- The benefit diminishes rapidly: most of it arrives in the first fifteen to twenty genuinely distinct positions.
- It requires the positions to be distinct. Twenty holdings in one sector are not twenty exposures.
The last point is the one that makes position counts misleading. Diversification is a property of the exposures, and counting names is a poor proxy for counting exposures.
Scroll the chart sideways to see all of it.
The skew in individual returns
Research on long-run individual stock returns finds a strongly skewed distribution: a majority of stocks underperform Treasury bills over their lifetimes, and the aggregate market return is driven by a small minority of enormous winners.
| Implication | Direction of the argument |
|---|---|
| Missing the few large winners is costly | Argues for broad diversification, to hold them by default |
| Most positions will disappoint | Argues for diversification, since the median is poor |
| The winners are enormous | Argues for concentration, if they can be identified |
| Identifying them in advance is very hard | Argues against concentration for most people |
The finding cuts both ways and is used by both camps, which is unusual and honest. What it establishes unambiguously is that the outcome distribution for a small number of positions is very wide.
The case each side makes
| Concentration | Diversification | |
|---|---|---|
| The claim | Returns come from a few positions, so hold those | Nobody reliably identifies them in advance |
| Requires | An identifiable edge in selection | No edge at all |
| Outcome range | Very wide, in both directions | Narrower, centred near the market |
| Failure mode | One position ends the plan | Never much better than the market |
| Behavioural demand | Very high, since a large position can halve | Lower, though not zero |
Neither column is a recommendation. The choice depends on whether a selection edge exists, which is a claim that requires evidence, and on whether the outcome range is survivable, which is a personal constraint.
The asymmetry that decides it for most
There is one structural asymmetry worth stating. A diversified portfolio that performs poorly produces a disappointing outcome; a concentrated portfolio that goes badly wrong can end the plan entirely, and recovery from a very large loss is superlinear in the size of the loss.
This is why the question is usually not which produces the higher expected return, but which failure is acceptable. That is a question about circumstances rather than about markets, and it is not answerable in general.
The concentration nobody chose
Portfolios frequently become concentrated without any decision, and the routes are consistent enough to check for.
- A winning position growing into a dominant weight, which is drift rather than conviction.
- Employer stock through compensation, which correlates with the salary and the career.
- Several holdings sharing one exposure, so the position count overstates the diversification.
- An index whose top constituents have grown into a large share of it, which concentrates a fund that looks diversified.
The fourth item is a real change in a widely held product. A capitalisation-weighted index whose largest handful of constituents represent a substantial share of its value is more concentrated than its constituent count implies, and the holder made no decision about it.
The check that catches all four is to list actual exposures rather than positions: which economies, which sectors, which factors and which single companies account for the largest shares of the total.