In the second, diversification comes at a high price: The more diverse the portfolio, the lower its expected returns. Such an environment calls for a concentrated portfolio, subject to the lower bound discussed earlier.

But what about the time cost of diversification? Underwriting new investments takes time away from underwriting the existing ones. This might seem like a problem that could be solved by adding resources, say by hiring analysts to process more potential investments.

But I don’t buy this approach. In my model, certain aspects of the investment process are too critical to be delegated: To do so might lower the quality of the work or, at the very least, my confidence in the conclusion. On paper a value range is a value range.

In practice, the skill and experience of the analyst matters. Since I will always be the primary capital allocator in my model, adding analysts or other resources cannot resolve all the inherent bottlenecks of assessing potential investments.

However, this factor is also environment-dependent. As a professional investor who has been valuing companies for 17 years, I know quite a few firms and industries.

So in an environment in which many industries and companies are deeply undervalued, I would not need much time to value additional companies and add them to the portfolio.

On the other hand, when opportunities are scarce and scattered in various pockets of the market, my learning curve on a potential new investment will likely be much steeper.

So diversification is worthwhile in environments where potential investments offer similar prospective returns or where undervaluation is widespread.

On the other hand, increased concentration is the logical course in environments where the opportunity cost — in both returns and time — of adding new investments to the portfolio is high. I set the upper bound for the number of investments at 20 under normal circumstances, which is consistent with my typical “small” position size of 5%.

Thus the portfolio will have between 10 and 20 investments under normal circumstances. The precise level of concentration within that range depends on the environment and the available opportunities.

So to return to the free lunch, the old adage holds true in investing and in life: There is no such thing — not even diversification.

This article has been republished with permission from Value Walk.