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The research presented in this paper aims to construct Warren Buffett-style, concentrated portfolios based on two main criteria, size and quality, in order to investigate the diversification and risk reduction in concentrated, quality portfolios. We construct the concentrated index portfolios with companies that are leaders in quality following the method of Asness, Frazzini, & Pedersen (2018). Our research indicates that for any number of stocks in a concentrated portfolio, quality portfolios have less risk than portfolios constructed with random stocks. Consistent with the literature on the quality factor and the low volatility effect, we find that low-risk, quality portfolios have excess mean returns over the diversified market portfolio. Finally we show that the risk of a quality constructed portfolio does not decrease monotonically as the number of ranked quality stocks is increased. Instead, we find that the risk of quality portfolios is minimized at about 10 stocks and that increasing the number of stocks in the quality portfolio actually increases the standard deviation and beta risk. We refer to this increase in risk of the quality portfolios with an increasing number of stocks as the quality dilution effect. While Buffett has long argued that holding a large number of stocks about which he knows nothing seems risky to him, we believe that our research is the first to provide empirical evidence for that assertion.

Finance, quality, portfolio diversification