The majority of actively-managed equity funds that exist today utilize conviction-weighted position sizes. The reasoning behind this approach is that the portfolio managers managing these funds believe they have an edge by overweighting their favorite stocks relative to the funds’ benchmarks. It’s common for concentrated portfolios (say, fewer than 40 holdings) to have around 25%-30% in their top-five holdings.
In theory, the practice of allocating relatively larger amounts of capital into a team’s best ideas makes sense, assuming it’s a skilled team. But in reality, the psychological biases of team members often result in unnecessary risks, such as heightened “idiosyncratic risk”. Also referred to as unsystematic risk, idiosyncratic risk is endemic to a particular asset such as a stock and not a whole investment portfolio.1 As a manager increases the active weight of any particular position, this introduces more room for excess performance, but it also increases idiosyncratic risk and diminishes the benefits of diversification.
Consider this hypothetical, yet realistic, scenario.