Portfolio Diversification

13th Oct '21 by Monty Carlo

6 comments 589 reads

I originally wrote the below in an SCVR thread, but Stocko is very light on detail when it comes to portfolios and risk management so I thought I'd add as a topic here:

On diversification in general there seem to be four approaches:

1. Put your eggs in one basket - watch it very carefully (Warren Buffet)
2. Hold the maximum number of shares you have the time to monitor
3. Hold a concentrated portfolio to maximise divergence from a performance benchmark (i.e. maximise return on stock selection)
4. Take the mathematical approach of seeking to diversify away a large chunk of the stock specific risk.

I would argue Option 1 is for the full time pros who know their companies AND can afford to take a big hit without changing their lifestyle, or for the gambler who enjoys the ride.

Option 2 is for the keen amateur investor with a day job holding positions in a SIPP alongside a company pension, the enthusiastic private investor using an ISA etc alonside other savings.

Option 3 is for fund managers who need to market their fund and demonstrate they are not index huggers. By all means hold these funds (e.g. Fundsmith) but don't put all your money into just one of them! Hold a basket of them and mind the overlaps.

Option 4 is for those private investors who are "all-in" and rely on their portfolios to fund their livelihoods. It is not always possible to spot fraud, the unexpected happens, and the professional fund managers frequently get things embarrassingly wrong too. Diversify to protect yourself because you realise just how ignorant everyone is, and nobody can predict the future. The maths says you can diversify with as few as 20-25 holdings, but in practice you are looking at 50-70 stocks once you take into account sector concentrations and factor correlations. If you include liquidity risk because you hold small & mid-caps then it can be sensible to hold well over 100 positions. I will take some flak for saying this as it isn't fashionable, but in investment being fashionable doesn't work for long.

Of course you can cut corners with ETFs, investment trusts etc, at the expense of paying someone else to diversify for you. They make a lot of sense for overseas markets... just try dealing in Japanese equities or reclaiming withholding…

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gus 1065

14th Oct '21

Pleased to see you managed to recover your original text - good idea to put it on its own thread as this is a recurring topic for discussion. Thought I would copy and paste my comment from yesterday’s SCVR which probably makes a bit more sense when put in context. I just read your thumbnail bio below - it looks like we have followed a similar life pattern (ex financial services, now dropped out to bring up the family) although I suspect I’m a bit further down the trail as it’s my youngest’s 21st birthday today! Love the Bladerunner reference. I’ve a few City scars to bear too.

Gus.

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Hi Monty Carlo.

I think that’s a very good summary of the different investment styles. I’m firmly in the fourth group having chosen not to be employed but not drawing a pension so living on portfolio income and capital. I’m also probably at the extreme end of the diversification spectrum having well over 250 individual shareholdings as well as a fair chunk held in ETFs, Investment Trusts and OEICs which I use to give me diversification outside of the U.K. and into other asset classes such as property and commodities. The costs of these pooled investments can be pretty low nowadays, as little as a few basis points per annum for some of the larger and more liquid funds/ETFs, which are little more than rounding errors in the scheme of things. Happy to be unfashionable (you should see my wardrobe) and with this level of diversification able to be reasonably sanguine when a company in the portfolio has the occasional brain f**t. With so many open positions I now find it less stressful trying to keep track of the portfolio than when I had a much smaller concentrated group of larger holdings where one good or bad piece of news could have a marked impact on the whole. Each to their own.

BnB

I used to be option 1 in that I held large stakes in businesses that I had a part in founding. This meant a >5% stake in listed entities or a majority stake in private enterprises. This approach pretty much eliminated concentration concerns because my knowledge of the companies’ performance was guaranteed by a position on the board. On the other hand, I found it gave no protection from the vicissitudes of the market - one very successful IPO never recovered from the subsequent dotcom crash even though the business was never a tech company.

Nowadays, at an age below retirement but living off my capital, I’m in camp four. Investing thematically means picking multiple promising representatives for each trend, and, as the themes multiply and proliferate across multiple geographies, so the individual holdings compound. I’m at over 300 today.! On the negative side, despite having plenty of spare time, this is a large number of names to track and I could more efficiently manage my time - and capital gains - simply by investing in 10-20 thematic ETFs. However, I’m addicted to business ownership and the multiple direct holdings reflect, on the one hand, my need to see my capital at work and share in the fortunes of its stewards, and, on the other, an acknowledgement of my limitations as an analyst and investor.

The obvious question, as the portfolio and my skills develop, is whether I will narrow the positions into a more contracted form, approaching the “ideal” 30 position portfolio. Somehow I doubt it. I’ve been able to shrug off the collapse of a couple of positions as representing a move of only 25bps, which is less than half the daily average volatility of the whole portfolio. So I will probably continue to suffer the corollary - each of my best performing shares barely represent 1% of the portfolio, and these are multibaggers, though they are as plentiful as you’d expect from such a wide selection.

The ultimate test of one’s approach isn’t just mathematical. Investing is an emotional process and its success is measured in good sleeps as well as compound returns. I’d be interested to hear other’s perspectives. Good luck to all.

timarr

I'm sort of in Option 4.

However, as described, there's no difference between Option 4 and a decent tracker other than cost. Investing thematically, though, is a different matter. If you believed in 2010 that the internet would crush costs for companies capable of using it effectively then it would have been entirely sensible to invest in a basket of relevant companies rather than trying to secondguess the winners.

In fact, investing in multiple companies in the same area reduces the idiosyncratic risk of any of them going wrong individually while still exposing yourself to the (presumed) upside. It also has the distinct advantage to forcing you to avoid micro-analysis of companies at the cost of occasionally missing something obvious. More often, though, benign neglect tends to work perfectly well - overtrading is the curse of the private investor.

Personally I found early on in my investing career that my conviction holdings did relatively badly. Some of that was clearly due to confirmation bias and groupthink driven by fora such as this (it's remarkable how often popular bulletin board stocks underperform). Some of it was just pure ineptitude. Discovering that I could invest in 60+ stocks, outperform, sleep soundly at night and indulge in the joy of hobbyist stockpicking was a bit of a revelation. I recommend it to anyone who gets stressed over investing.

Morning BnB.

Interesting post. Thinking about it, I guess I was a Cat 1 at one point too. I was effectively barred from buying individual stocks by my employer (makes sense if your day job is buying companies!) so I was either invested in passive tracker funds or a few legacy equity positions held for many years and one or two PE style co-investments. Fortunately one of these came in big time (it was an 80 bagger) which gave me the means to get out of the Rat Race. I still enjoy the thrill of the chase, hence a bit of a scatter gun portfolio of many smallish (in percentage of total pool terms) holdings and only one or two large conviction positions that have the capacity to hurt when they tank.

Monty Carlo

My kids are still in primary school. Long road ahead.

They are both delightful and utterly infuriating, often at the same time. I think Jeremy Clarkson had it right when reviewing a Maserati - I paraphrase.... "it's like a 2 year old, it'll drive you mad but if anyone takes it away you will kill them".

I'm Option 4 and I agree with benign neglect (or buy & hold as I call it) in many areas, but not all. I hold between 100-200 holdings, but I delve into lots of areas that are difficult to access via trackers.

On the subject of trackers & passive ETFs (physical only please)...

They have their place and I regularly "recommend" them (but not in FCA terms) to people who just want to forget about their portfolios and come back in a decade. Whilst Warren Buffet is over-quoted and gets away with running a giant hedge fund while playing the friendly uncle (OK...leveraged insurance float...I'm being flippant), his advice there is sound.

There are, however, some real problems with trackers:

Tracker funds don't solve asset allocation for you, and asset allocation dwarfs stock selection in the long run. People get hung up on relative performance when the big question should be how much of your wealth should be in equities.
Market weighting - I would much prefer a constant-weighted portfolio to a market cap weighted index (remember the Vodafone/FTSE debacle?). However the re-balancing costs mount up.
Sector concentrations - FTSE 100 well known for this
They can struggle to physically replicate small & mid cap
They can be morally problematic. Passive investors are not making a capital allocation decision between companies, which undermines the market's role in capital distribution. Investors are not incentivised to act as responsible shareholders. Investment trusts are better in this regard.
The efficient market hypothesis is merely a hypothesis - it is given far too much respect and taught as fact when it shouldn't be.
Trackers are boring.

On the plus side:

Convenience - you avoid single-stock corporate actions, dividend reinvestment etc.
You can get some access to stock-lending revenues to offset your costs (check the small print in each jurisdiction).
Cheapest way for smaller investors to achieve diversified exposure.

Personally I tend to opt for investment trusts over trackers, but I agree there are some markets where the evidence for consistent active outperformance is sketchy.

Portfolio Diversification

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Monty Carlo

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