Thursday, October 15, 2015

Diversification - A Controversial Notion

People ask me all the time if their holdings are diversified enough. It's probably the single most-common concern among investors: are they sufficiently protected against a net asset loss event. And like most such questions, the answers vary dramatically depending upon that individual's situation, needs, tolerance of volatility, tolerance of risk, and level of involvement in the investment portfolio.

The concept is simple enough, and probably 95% of analysts and financial planners will tell you diversification is one of the key factors in managing the risks associated with any single investment. Just spread your invested dollars across different asset classes, different industries, market caps, global regions or even countries:

Asset classes--
  • Stocks, or Equities
  • Bonds, or corporate/municipal debt
  • Commodities like copper, wheat, natural gas, pork bellies
  • Real Estate
  • Treasury bills
  • Collectibles like art, vintage automobiles, sports memorabilia, fine wines, etc
  • Cash, or cash equivalents

Market cap--
  • Small cap (company valuation $300 million - $2 billion)
  • Mid-cap  (company valuation of $2b - $10b)
  • Large cap (company valuation upwards of $10b)
(For more details on the asset classes and what broad diversification would involve, read this great NerdWallet overview.)

With proper diversification, if a substantial pullback hits U.S. biotech, or South American heavy equipment manufacturing, that investment makes up a small portion of your overall portfolio so most of your money is ok. Imagine you had a big stake in light crude oil a few years ago, before prices fell over 60% globally due to a supply glut ... It simply makes sense to make sure your eggs are in more than one or two baskets. 

But here's the thing: I've been a committed investor for over 20 years, and I've done very well. But I've always been poorly diversified and I have no plan to become more so. My portfolio weathered the tech bubble popping and following pullback from 2000-2003, and the great recession of 2008-2010. It was painful to watch, but I found that patience alone got it done: wait it out and everything comes back.

The problem for me is that diversification requires two things I've been unable to withstand. First, diversifying means investing broadly rather than deeply, which ensures average returns. The more different classes or industries or countries you place your money in, the less any one catastrophe can hurt you-- and the less any one home run can help you. I work hard to position my money just so. I'm swinging for home runs: Apple, Netflix, Starbucks, Tesla.

The second reason, as I've discussed on this blog before, is that I invest in things I know, things I understand, things I already pay attention to. It's the only way I know to get consistently positive returns. When I wander off that path, I fail at a rate close to 50%. And I just don't have enough familiarity or understanding of everything on the planet to intelligently make those choices. Brazil or China? Casinos or publishing or health care? Beats me. I'll stick to my knitting.

Certainly I am diversified to a point. I own stock in a number of American companies which derive a substantial portion of their revenues from countries outside the U.S., including Amazon, Disney, and Starbucks. I own stock in some huge large-cap companies, including Apple, Google -- sorry, Alphabet-- and Berkshire Hathaway, as well  as some mid-cap companies like Zillow and FireEye. My smallest-cap is Imax, maker and licenser of those gigantic movie systems, but even that is a mid-cap. I have no small-cap stocks. 

A little over 10% of my assets are in real estate, a portion which was once much higher and which I'd like to increase again. And I have about 7% in savings, earning nothing, so I can take advantage of attractive opportunities that come along. 

Which means the bulk of my holdings are in large cap, consumer-facing businesses. I've got retail, automotive, insurance, banking, entertainment and social media in there, but even then most of those have a substantial tech component. So really I'm not at all diversified. Because that's the stuff I know, the industries and the companies I follow in the news, business models I understand and companies for whom I am a customer. 

My approach will not work for most people. Normally, investors want to put their money into something safe for a long time, and ignore it. They want asset growth, but also stability and forgettability. That means exchange-traded index funds which are more liquid and lower cost than mutual funds and which move up and down with the entire market, or segments of the market. Since the market always rises over long periods of time, they're happy and they don't have to worry. They don't have to know anything about the companies and they won't be brought down by any big pullback-- in the long run. 

It's a good solution, but it doesn't work for me. Again and again I choose volatility and company-specific risk if it gets me faster growth, and I'm willing to ride the roller coaster through the big dips. I've studied my companies and I've chosen carefully. I'm patient with my holdings and encourage and nurture my portfolio as if I'm growing a bonsai tree. It works, and it's the only way I know 

Diversification is just not for me. 

Drifting to Fifty | Random unrelated nugget of the week

Broaden your musical tastes. Try some jazz, a little R&B, international, even country. The choices are endless, easy to sample, and have never been more inexpensive. Good music enriches your life and will pay dividends forever.

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