Let’s try to understand diversification and concentration from a different perspective. Suppose you are part of a bet where the probability of winning is 50%. Payout is 3x of your bet amount if you win, making it a favourable bet for you but you risk losing the entire bet amount if you lose the bet.
How many such bets should you make?
The right answer is as many as you can. In any one bet, you might lose the entire bet amount, but in large number of such bets you are almost guaranteed to make money.
Before you decide to put money into a bet, first determine what’s an acceptable payout for you. Only you can determine that for yourself. Some people want 3x, while some people may want 10x. Then determine how much risk you are willing to take on each bet i.e. what are the odds of winning or losing.
Once you have decided your acceptable payout and odds, divide your money into as many such bets as you can.
Applied to stocks, you must first determine what returns are acceptable to you and how much risk you are willing to take. Then divide your money across as many stocks as you can find that meet these criteria.
This will yield a fairly concentrated portfolio if your return expectation is high but risk is low (Warren Buffett style investing as you won’t be able to find such ideas very often). A moderately diversified portfolio if return expectation is high but risk is also high (Small/mid cap investing as you can find such ideas but there will be some red flags/lack of history) and fairly diversified portfolio if return expectation is low and risk is low (Mutual fund style investing/ as there will be plenty of ideas that are tried and tested but their high valuation will yield low returns).
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