Billionaire Investor Bill Ackman Bets Big and Wins Big. Is a Concentrated Portfolio Approach for Everyone?

Billionaire Bill Ackman is one of the world's most renowned investors. He's a value investor who runs a highly concentrated portfolio, with just 15 stocks as of the end of May. Given his strong long-term track record, it's natural for investors to wonder: "Is a concentrated portfolio right for me?"

Among hedge funds, running a concentrated long portfolio isn't unusual. Fund managers are paid based on performance, so they often load up on their highest-conviction ideas. That makes a lot of sense.

But let's peel back the onion a bit. I previously worked as an equity analyst at a hedge fund with about $600 million in assets under management. While that sounds like a lot, it's modest compared to Ackman's $18 billion Pershing Square portfolio. Like many others, we ran a concentrated book on the long side, typically 15 to 20 positions.

Our short book, however, was very different, usually holding more than 50 names. Shorting is inherently riskier, so you want to spread out your bets. If a long goes against you, it gets smaller, and you can add more. But if a short goes against you, it gets bigger, and you're often forced to trim or take a loss. Even if your thesis eventually plays out, bad timing can still cost you.

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Why hedge funds often run concentrated portfolios

On the long side, professional investors tend to be more comfortable with concentration because of the resources they have. Even at the fund where I worked, we routinely tapped experts to gain deeper insights into businesses. We used expert networks to connect with former executives, industry insiders, customers, and even rivals, which is a common practice in the hedge fund industry. Some funds even use web-scraped data, credit card transaction data, or satellite imagery to get an edge. Large investors also get better access to management. I spoke to the CFO of one of our larger positions every quarter, and I'd often follow up with direct contact after any major news.

In short, professional investors simply have more tools at their disposal, and that's why concentrated portfolios can make sense for them. But they also come with more risk.

I'll never forget when my portfolio manager added a small position in a stock he hadn't researched, simply because a "smart" fund manager had gone all-in on it. That stock eventually went bankrupt, and that fund manager lost everything. That's an extreme case, but it highlights the risk of too much concentration.

It's also worth noting that stock picking is hard. A J.P. Morgan study found that between 1980 and 2020, about 40% of stocks in the Russell 3000 delivered negative returns, and two-thirds underperformed the index. Meanwhile, another 40% of stocks experienced a catastrophic decline of 70% or more and never fully recovered.

A better approach for individual investors

While concentrated portfolios may work for the pros, most individual investors are better off with a more diversified approach. Owning more stocks could require more research, but I don't think researching a whole bunch of individual stocks to create a large diversified stock portfolio is the best use of most investors' time. After all, professionals already have a data edge.

Instead, I think the best option to get diversified exposure is through an index exchange-traded fund (ETF) like the Vanguard S&P 500 ETF (NYSEMKT: VOO). It tracks the performance of the S&P 500 (SNPINDEX: ^GSPC) and gives you instant ownership in about 500 of the largest U.S. companies.

The S&P 500 is a market-cap weighted index, which means that the larger a company is, the higher its portfolio weighting is in the index, and the more effect it has on the index's performance. With market-cap weighted indexes, the biggest winning stocks naturally become a larger part of the index over time, while underperformers shrink or drop out. This dynamic is a big reason why the S&P 500 has outperformed most professional managers over the long run. The S&P 500 lets its winners run, while fund managers tend to double down on their losers and trim their winners.

I do think investors should still buy individual stocks if they've done the research. But for a core holding, I think an index ETF like the Vanguard S&P 500 is the smartest foundation from which to build a winning portfolio.

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JPMorgan Chase is an advertising partner of Motley Fool Money. Geoffrey Seiler has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends JPMorgan Chase and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.