Peter Lynch remarks, ‘All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out’.

Warren Buffett’s mentor and the father figure of ‘Value Investing’, Benjamin Graham, was persuaded by his business partner to make a 50% investment in the insurance company GEICO. This one stock returned 562 times the investment (from 1948 to 1972), a bigger gain than that returned by all of the firm’s other investments combined.

A glance at the returns for The Motley Fool Investor services ‘Stock Advisor’ and ‘Rule Breakers’ reveals that while both of the services are ‘beating the market’ most of the returns derive from a small handful out of hundreds of stock selections.

Shelby Davis made his initial fortune from just a small handful of insurance stocks.

The iconoclastic CEO of Teledyne, Henry Singleton, transformed the investment performance of his insurance subsidiaries by reallocating the investment portfolio from 10% equities to 77% equities. He then invested 70% of the equity allocation into just 5 stocks. This resulted in an eight fold increase in book value in a single decade. Charlie Munger said of him, ‘Like Warren and me, he was comfortable with concentration…’

This is not a phenomenon confined to individual investors. In 2014 55% of the returns of the S&P 500 index of stocks came from just 36 out of 500 stocks. And 20% of the returns came from just 5 stocks.

When you construct a portfolio of stocks, it may be evenly balanced initially, but over time a small number of stocks will outperform and begin to dominate the portfolio.

The way in which you handle this will be crucial to your long-term success. If you follow conventional advice and re-balance regularly, you will be ‘cutting the flowers to water the weeds’.

Nevertheless, if a stock grows to forty or fifty percent of your portfolio, it creates a significant concentration of risk. Different investors have different risk tolerances. Some would baulk at having a single position exceed 10% of their portfolio, while others may happily see a position in which they have conviction rise to 50%.

The point at which a position size becomes so risky that it should be trimmed depends upon the quality of the business, and your conviction in the company. When the right opportunity arises, successful investors are prepared to commit a huge percentage of their portfolio to a stock in which they have high conviction.

Back in 1963, American Express was embroiled in a major financial scandal and the share price collapsed from $65 to $37. After carrying out careful research, Warren Buffett became convinced that the company was fundamentally sound and invested 40% of his fund in the company. The subsequent rebound in the stock was one of the main catalysts that set Buffett on his way to becoming the world’s greatest investor. This behaviour was not atypical for Buffett. At an even younger age he had invested $13,000 into GEICO – a minuscule amount for Buffett today, but at the time it represented 65% of his capital.

Although they are content to make huge bets, successful investors will at some point bring their portfolio back into proportion. They do not act blindly or stick to percentage limits. When they feel that the price of the stock fairly reflects the value of the business, they reallocate accordingly.

While these top players do not appear keen to keep their big bets (50% plus) allocated to a single stock for extended periods, they are content to allocate a significant percentage of their portfolio to high quality businesses indefinitely. As of March 2016 Buffett’s Berkshire Hathaway had 21% of its equity portfolio invested in Kraft-Heinz, 18% invested in Wells Fargo, and 14% invested in Coca-Cola.

The stock market has had many great success stories, stocks such as Berkshire Hathaway, Apple, or Dell computer in the 90s. But if you had ‘rebalanced’ a portfolio containing these stocks when they first doubled you would be throwing away a fortune.

If you can recognize quality businesses, and have the temperament to hold them through thick and thin, then you have found the secret to great investing.

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