Concentrate on 'Concentrating' your Microcap Portfolio

The age-old debate of portfolio diversification vs. portfolio concentration is as relevant today as it was decades ago. Similar to almost all my educational blog posts, my conclusion here is that there is no 'one size fits all' and it depends on many personal factors as to how much 'concentration' within your microcap portfolio is right for you. I would argue, however, that if you are a microcap investor that is passionate about continuing to learn about the businesses you own to the point of obsession, then the best opportunity to create significant wealth is through portfolio concentration. 

Before getting into portfolio concentration, let's quickly talk about portfolio diversification. Chances are, if you are like me, you have a 401(k) account through your employer or a self-directed IRA account that you put a defined amount of funds into periodically for the sole purpose of building your fund for retirement. These types of accounts are generally for passive, hands-off investing in mutual funds and/or ETFs. In other words, your allocations are highly diversified within the funds themselves and you set the contributions on auto-pilot and look at your account value each quarter when you receive your statements. Your 401(k)/IRA are meant to be diversified because within your accounts there are hundreds and hundreds of companies that you indirectly own via the investments in various mutual funds. Diversification within these accounts allow you to roughly achieve market returns, and are the 'safest' way to save for your ultimate retirement because, well, generally markets always reach new highs over time. Your saving for your retirement and these vehicles allow for highly diversified ways to accomplish that in ways that you do not need to truly "understand" what you own, other then ensuring that your allocation is setup correctly and reviewed periodically to make sure that as you get older you move from a less conservative to a more conservative allocation mix.

But we aren't here to talk about 401(k) and IRA accounts. We are here to talk about microcap investing, and microcap investing allows you the opportunity to create serious long-term wealth by investing in tiny companies that have the potential to become large companies. Investing in microcaps is extremely difficult, requires a tremendous amount of patience, and demands constant diligence into your positions....but if done correctly (with a little bit of luck of course!), your investment returns can be phenomenal. 

I would strongly suggest that a highly concentrated microcap portfolio is the only way to put yourself in a position to achieve such phenomenal returns. At the time of this writing, my top 3 positions in my portfolio account for 85% of my total portfolio. My largest position currently accounts for 40% of my total portfolio. While I am extremely concentrated in my top 3 positions, I do not feel like it poses a significant overall risk that outweighs the potential for incredible returns. My feelings are that when you find great companies you need to make sure you own enough of them, otherwise, what is the point? 

Here are the top four reasons why I feel being highly concentrated in your microcap portfolio is a strategy that most microcap investors should embrace:

1. The fewer companies you own, the more time you can devote to learning as much as you can about them, and this is absolutely critical for long-term success in microcap investing. If you know more than most about one of your investments, you can then confidently take advantage of volatility in the stock to build your position over time by taking advantage of emotional investors who sell out of fear or lack of understanding. Simply stated, knowing your investments better than most gives you the conviction you need to hold (and add) thru tough periods in time.

2. One of the many benefits to me of investing in microcaps is that you don't have to be glued to your computer screen all day. As I like to say, illiquidity is a microcap investor's best friend. By having a highly concentrated microcap portfolio, there is not much "day to day" activity you need to worry about. Set price alerts if you want and sign up for news alerts on the company, but otherwise just go about your day and make sure you build in just a little bit of time to learn something new about each company you own on a daily basis.

3. You can be diversified within a concentrated portfolio. What I mean by this is you can position yourself in companies that have highly diversified revenue streams spread across a large customer base with technologies that have significant barriers to entry. In other words, there are many company-specific factors that can mitigate risks of "over-concentration". 

4. You don't have to be right with every position. I have had to learn, over time, that selling a company when its progress (or lack thereof) was deviating from my original investment thesis is ok. If you are highly concentrated with your portfolio, and you understand that limiting a loss on a position is ok, it only takes superior execution by another one of your holdings to make you quickly forget about any previous mediocre returns or losses. 

The concern that scares many investors away from being highly concentrated is the thought of "what happens if something bad happens to one of my positions?" First and foremost, if you strive to learn all you can about what you own, you are likely to instinctively know that there may be a problem looming, allowing you time to get out or sell some of your position if you are that concerned. Yes, it is inevitable that at times something unforeseen may happen that will send the company stock down significantly, but unless it is something that is going to force the company out of business, always remember that microcap stocks that have delivered the biggest returns have had periods of significant underperformance, with their stock price dropping 40-50% (or more) from their highs during multiple moments in time over their business cycle. If it is something that was totally unforeseen that truly may not be something that company can recover from, you have to just learn from the mistake and move on. Easier said than done, but shit happens and risk is never 100% avoidable. 

For further reading on this topic, I would encourage you to read my friend Ian Cassel's articles, "Life is Too Short to Diversify" and "Microcap Portfolio Management and Position Sizing". I also encourage you to consider joining MicroCapClub as topics such as these are discussed frequently among a group of successful investors who strive to continue to be the best they can be.

As always, feel free to leave comments below to engage with others and myself on this topic.