The debate between investing directly in individual assets versus holding a portfolio of assets is a common one among investors. Both approaches have their merits and drawbacks. Those advocating for direct investments point to the potential for higher returns by concentrating capital in your highest conviction bets. However, this comes with significant risks as lack of diversification magnifies the impact of any single investment. On the other hand, portfolio investing provides diversification to mitigate risks but reduces the potential for outsized returns. Ultimately, the right approach depends on an investor’s goals, time horizon and risk tolerance. Many suggest a blended approach allows playing to the strengths of each. This article will examine the key pros and cons of portfolio versus direct investing to allow investors to make an informed decision.
Direct investing allows concentrating capital in best ideas
The ability to put a large percentage of capital into one or several high conviction investments is a key advantage of direct investing. This concentration raises the upside if your investment theses play out successfully. For example, investing a significant amount directly in Tesla stock in the early 2010s would have delivered exponential returns. Such concentrated bets carry much more upside potential than holding Tesla as part of a diversified portfolio. However, the flip side is direct investing magnifies the downside if your investment theses prove incorrect. Many direct investors have lost fortunes on concentrated bets that soured. Overall, direct investing is better suited to those with very high conviction in a limited set of investments and the risk tolerance to stomach significant volatility.
Portfolio investing reduces risks through diversification
The main benefit of portfolio investing is risk reduction through diversification. By holding a basket of assets across different sectors, geographies and asset classes, the poor performance of any single investment has a muted impact on the overall portfolio. This makes portfolio returns more consistent over time. Investing in a portfolio also requires less due diligence per investment, as research resources are spread across the various holdings. However, diversification also limits the effect of your best performing holdings. Even if you hold the next Amazon in your portfolio, it will likely only comprise a small percentage of the overall portfolio. This dilution caps the upside. Investors need to be comfortable sacrificing potentially outsized returns from concentrated bets in exchange for greater consistency and lower volatility.
Each approach suits different investor profiles
In summary, direct investing is better suited to investors who have very high conviction in a limited set of investments, possess deep understanding of these investments, desire potentially outsized returns from concentration and have the risk appetite to endure volatility. Portfolio investing is more appropriate for investors who prefer consistency in returns, seek to mitigate risks through diversification, wish to minimize time spent researching individual investments or have lower risk tolerance. Many experienced investors advocate taking a blended approach – using direct investing for your highest conviction ideas while still maintaining a diversified portfolio as the core holding. This allows focusing capital on best ideas while still getting the risk management benefits of diversification.
Direct investing and portfolio investing represent two ends of the spectrum, with each approach having merits and drawbacks. Direct investing allows concentration in best ideas but lacks diversification. Portfolio investing provides diversification but reduced upside potential. Ultimately, the right approach depends on an investor’s specific profile and goals.