Diversifying investment portfolio

[DeepState]

Its pretty clear what his view is on portfolio diversification, he states it in simple terms in the linked videos and in other interviews, writings, transcripts etc.

Not specifically making a direct response to you, Galumay...just bouncing off your comments...the below has been on my mind a bit given recent exchanges. Thought I'd open the floor given the context seems right in this thread.

Here's a good example of his views, I think, given it is him speaking:



Here's a given: you don't get seriously rich by 'dabbling'. The truly rich take big positions.....*


Question 1: Listening closely...Under what conditions are highly concentrated positions ('6 businesses' (1:05)), when thought of as a stock level bet, truly appropriate? How closely are these conditions aligned with those who have extensively espoused the Buffett way as their mantra in all these threads?


Question 2: Who is in line to take over the BRK portfolio when Buffett is gone?


Question 3: How many stocks do they own? Presumably, as presumptive heirs to the throne, they are pretty much the very best investors in the world.


Question 4: Of the 'twenty punches' (1:55) in their punch-cards, how many have the presumptive heirs used in their investment careers to date, even before they have assumed the throne, even allowing only for the period after they were called to the clan?


Question 5: What if, with some humility, your working model is to assume that you might not quite be as good as the presumptive heirs, let alone Buffett. What does that mean? If 'maybe more than 99% of investors should extensively diversify' (0:20) and the best of the best of the best that aren't Buffett hold what they hold with multi billion dollar portfolios....what would that mean for a level of genius that ranked someone at 98% (a level that would get you into Mensa if this were IQ) with more liquidity?


Question 6: Despite having the very best choice of investors available to him and likely in place for his eventual retirement from BRK, how many stocks are in the portfolio that he wants managed for his wife when he is gone? Why would that be if the Buffett/Fisher/Graham approach is so well codified that the accolytes can read books, watch videos etc... that outsized profits should be easily found amongst the legion of followers? The moment before this death, his wealth is mostly in BRK. But that is not appropriate for his wife after he is gone??? The polar opposite, actually. Maybe it isn't quite so straight forward after all?


Question 7: Given there are other pretty good investors in the world, how many stocks does Soros, Dalio, Fink, Marks, Lynch... own or have owned? What about private markets players like Blackstone..the kings of big, concentrated, bets? I'll glance over the algo guys for the minute. If somewhat more than 6 at a time, or more than 20 in a career, are they not serious investors too whose viewpoints on diversification ought not receive quite a bit of airtime?


Clearly there are many paths to Rome. However, it does not appear that many of those which are actually being travelled by excellent investors, including the BRK portfolio heirs, point to the literal words of Buffett as oft repeated here and held as absolute truth...at least by some. That suggests, to me, that diversification beyond ultra concentrated and ultra low turnover portfolios of Buffett-speak fame is probably a good starting point if you don't happen to be Warren himself.



* Buffett, in this video, did not mention that this also applies to the truly poor. There are a whole lot more of these than the truly rich.

 

[Triathlete]

Here's a given: you don't get seriously rich by 'dabbling'. The truly rich take big positions.....*


Question 1: Under what conditions are highly concentrated positions ('6 businesses' (1:05)), when thought of as a stock level bet, truly appropriate?

I can only speak from my own experience but I look for stocks that are moving up in price and get rid of any that are moving sideways for any extended period of time and also get rid of any that have turned down which are in the portfolio,this is actively managed portfolio .

All my selections are confirmed by my technical analysis bias but I also make sure that they are fundamentally sound companies as well.

By using this technique I am able to generate much higher returns then the market.

Over the past 8 months this concentrated portfolio ( I have two that I run the other has 9 stocks in it ) had only 3 stocks in them 2 x top 20 and 1 x top 100 ,presently that portfolio has one ( top 100 stock)which is still moving up but am expecting a correction shortly so I have a trailling stop 5% below but over this 8 months has shown 50% return pa capital growth only.

I have closed out the other 2 positions and waiting to get back in when the time is right.The return so far on a PA basis is 39% includes div for this concentrated portfolio.

 

[Triathlete]

What are people views on this statement?

I have learnt and read that holding between 5 - 12 stocks is best as anything above 12 stocks exposes the portfolio to market risk,which cannot be eliminated by diversification.

Thus, any attempt to reduce volatility by increasing the number of stocks held actually decreases the ability of a portfolio to outperform the market because with each additional stock you are increasing your exposure to market risk, resulting in average returns at best.

 

[galumay]

By using this technique I am able to generate much higher returns then the market.

The problem is that statistically this is meaningless and you have no way of knowing whether its a bad technique that has got lucky, or a good technique that has got lucky, or a good technique without any luck.

The maths is pretty straightforward, but to likely exclude luck as a causal factor you need to consistently outperform the market for very many years. Of course even then it doesnt prove it wasnt just luck, but it becomes statistically improbable. There are very few investors in the world that can confidently say that their strategy or technique succeeds because of its own design and not because of luck.

 

[galumay]

Clearly there are many paths to Rome. .[/SIZE]

Without answering all your points in detail, i think this is the real learning. Like everything in life, there are few absolutes, most questions have answers in shades of grey, not black and white.

I think the other thing you have to be aware of with Buffett is that he is speaking in 'Omaha', the meassages might sound simple and clear, but I suspect more often than not he is simply trying to get his listeners to engage in second level thinking and unpack his simplistic, motherhood statements and think about the component parts and context.

Often when I read something Buffett said, rather than just accept it literally it inspires me to go and research the concept and improve my understanding. As you allude to, none of us will ever be another Buffett, for one thing even he suggests he couldnt achieve his record if he had to start in todays markets, so trying to emulate him is futile.

To drag the conversation back to diversification, i think its clear there are many ideas out there about the ideal way level and method of diversification, I guess the best we can do is truly understand what we are trying to achieve with a specific type of diversification, consider all the unexpected results that may occour and choose a strategy that we are comfortable with in terms of personal investing philosophy, emotional type and risk management.

It is interesting to think of diversification in other contexts too, from an internal business point of view its often considered high risk and contrary to the concept of concentrating on your core business. Similarly entrepreneurs tend to harvest one great idea and put all their capital, energy and intellect into developing that, diversification would be seen as very high risk and counter productive.

I dont think people should regard diversification as a panacea, nor should they dismiss it as something that never adds value.

 

[DeepState]

What are people views on this statement?

I have learnt and read that holding between 5 - 12 stocks is best as anything above 12 stocks exposes the portfolio to market risk,which cannot be eliminated by diversification.

Thus, any attempt to reduce volatility by increasing the number of stocks held actually decreases the ability of a portfolio to outperform the market because with each additional stock you are increasing your exposure to market risk, resulting in average returns at best.

Risk = volatility in this context.

You are exposed to market risk from the very first stock added to your portfolio. Depending on the stock, 'market risk' whatever that actually is, might be a relatively small portion of total risk. As you add more stocks, in general, volatility from market risk increases as a proportion of total portfolio risk. Total portfolio risk generally declines. The closer the portfolio effectively becomes to the 'market' in its composition, the less ability it has to outperform it as a tautology. Conversely, increasingly matching the index reduces the opportunity the portfolio has to underperform it too.

Number of stocks matters a lot less than the composition of the portfolio itself for all of the above statements. A portfolio with 200 stocks in from the ASX it can perform vastly differently to the ASX 200.

 

[DeepState]

Its pretty clear what his view is on portfolio diversification, he states it in simple terms in the linked videos and in other interviews, writings, transcripts etc.

...the meassages might sound simple and clear, but I suspect more often than not he is simply trying to get his listeners to engage in second level thinking and unpack his simplistic, motherhood statements and think about the component parts and context.

Maybe it's not so simple and clear after all.

I dont think people should regard diversification as a panacea, nor should they dismiss it as something that never adds value.

+1

 

[DeepState]

Last one for this spurt.

“I'm 15% Fisher and 85% Benjamin Graham.” Warren Buffett

Graham and Diversification:




Fisher and diversification:



Note the reference to 10 to 12 LARGER companies in a VARIETY etc. In the US those larger companies are much larger than the stuff that dominates the threads in the sharescene of ASF. All of those could fit into one US mega-cap with space to spare.


Not Fisher, Graham, Soros, BRK Portfolio Heirs, Fink, Dalio, Marks, Lynch....actually recommend or use 6 (or whatever very small number) stock portfolios.

Doesn't make it totally wrong for particular situations, however arguing that Buffett does it and thus it must be so assumes that the other conditions that make it right for Buffett also apply elsewhere....

Furthermore, crack open a BRK-US annual report and actually count the number of companies that are invested in to make that entity what it is. Look at the full portfolio that actually is BRK-US, let alone the float assets. You'll need more than two hands.

 

[galumay]

Last one for this spurt.

Not Fisher, Graham, Soros, BRK Portfolio Heirs, Fink, Dalio, Marks, Lynch....actually recommend or use 6 (or whatever very small number) stock portfolios.

Doesn't make it totally wrong for particular situations, however arguing that Buffett does it and thus it must be so assumes that the other conditions that make it right for Buffett also apply elsewhere....

Furthermore, crack open a BRK-US annual report and actually count the number of companies that are invested in to make that entity what it is. Look at the full portfolio that actually is BRK-US, let alone the float assets. You'll need more than two hands.

Did anyone actually argue specifically that Buffett holds a very small number of stocks? He certainly encourages the idea of holding a relatively small number - if you are a good enough analyst. (the punch card concept)

To be fair there are other reasons for BRK holding a larger number of companies, the sheer size of them makes it difficult for them to hold a small number of positions. (unless they owned 100% of a small number of rather large companies!)

 

[luutzu]

...assume that you might not quite be as good as the presumptive heirs, let alone Buffett.

To badly paraphrase Machiavelli:

The intelligent investor, in wishing to hit a lowly and distant target, ought to be like an archer and aim high above that modest goal. He thus ought to study the thoughts and actions of the great and the wise, and in him trying to emulate such greatness and fail, he will at least not drive his entire savings through the ground.

The super duper intelligent investor, in wishing to hit a moderate target, and in seeing that there is only one great and mighty Buffett, shy away and follow the advices of brokers, consultants, and other masters of the universe (who periodically crashes economies, wipe away people's life's savings but otherwise generally did just about so so) and thought it's the smartest and safest way to do just so and so like them.



Trick question: If I buy the Lotto and a PowerBall... does the chances of me winning both the Lotto and the PowerBall increased because I bought both? My year 10 introduction to probability tells me that the chances are the same - something about independent event and what not.

So if I blindly diversify and buy stocks on the ASX, and also stocks on NYSE, and some from emerging markets... some math genius or MBA could somehow tells me my equity risk is reduced because... beta and alpha and gamma says so?

Ah well, simple minds like myself have to do simple things.

 

[luutzu]

Last one for this spurt.

“I'm 15% Fisher and 85% Benjamin Graham.” Warren Buffett

Graham and Diversification:

View attachment 62288


Fisher and diversification:

View attachment 62289

Note the reference to 10 to 12 LARGER companies in a VARIETY etc. In the US those larger companies are much larger than the stuff that dominates the threads in the sharescene of ASF. All of those could fit into one US mega-cap with space to spare.


Not Fisher, Graham, Soros, BRK Portfolio Heirs, Fink, Dalio, Marks, Lynch....actually recommend or use 6 (or whatever very small number) stock portfolios.

Doesn't make it totally wrong for particular situations, however arguing that Buffett does it and thus it must be so assumes that the other conditions that make it right for Buffett also apply elsewhere....

Furthermore, crack open a BRK-US annual report and actually count the number of companies that are invested in to make that entity what it is. Look at the full portfolio that actually is BRK-US, let alone the float assets. You'll need more than two hands.

I heard Munger said that without a "handful" of great buys, Berkshire's performance is a joke.

"Handful"... so 5? 10?

See.... Geico, Sees Candy, Coke, Washington Post, Amex... Goldman [?]


Seriously, who take Buffett's "six" or twenty investment decision literally like that?

I thought the idea behind that was to know what you're buying, and if you're sure it's the real thing, buy it big... don't buy willy nilly... That and big opportunity does not come that often... but if it comes in 50 or 100 and you got the cash and the certainty, dig in.

 

[DeepState]

Did anyone actually argue specifically that Buffett holds a very small number of stocks? He certainly encourages the idea of holding a relatively small number - if you are a good enough analyst. (the punch card concept)

To be fair there are other reasons for BRK holding a larger number of companies, the sheer size of them makes it difficult for them to hold a small number of positions. (unless they owned 100% of a small number of rather large companies!)

No-one specifically argued that Buffett holds highly concentrated positions. He does. That is not a point of debate. What is under consideration is diversification in portfolios.

What you will have seen, even on this thread alone, is argument against diversification with Buffet's name nearby as a supporting justification complete with an obligatory motherhood quote or two.

You will also see references to holding concentrated portfolios for lack of ability to generate and maintain detailed knowledge. On at least some occasions, this is justified on the basis that investment is all about buying only what you know very well...implied by practice as being at the stock level.

Regrouping my points:

1. Buffett holds pretty decent diversification per the Fisher model. If you have less than 20 stocks, the bulk of which are in large, stable, businesses of different types, then you are likely under-diversified in the equity portfolio, particularly if this represents a decent portion of your assets.

2. If you know less than Buffett, then, in an extension to his own advice, it is appropriate to take a step towards highly diversified exposures to the equity risk premium alone. In at least some cases, those who know less than Buffett choose to hold very concentrated portfolios by stock count, by exposure to less stable/projectable earnings streams and/or by economic exposure.

3. If Buffett is invoked as a justification to maintain these types of portfolios, it is actually going against his practice and those of a great many other fantastic investors.

4. If you overestimate your abilities, but otherwise emulate the practices of those who are truly skilled, you are highly likely to be doing yourself a disservice. Given a reasonable working assumption is that there is at least a 99% chance that you are not as good as Buffett, some nod to highly diverse portfolio settings might be appropriate. It is important to calibrate risk with appropriate expectation. If you act in a manner consistent with being omnipotent, but are knowingly or unknowingly not so, excessive risk is being born. It isn't an issue of aspiration. It is an issue of calibration.

5. If you truly do understand risk management, are not over-constrained by various factors, and yet choose to hold concentrated portfolios then at least that is a direct and informed decision. It can be perfectly appropriate in the right circumstances.

6. Buffett deliberately sought to price BRK shares out of the market for a class of investors which would encompass many of the participants likely cruising around in ASF. Even for them, Buffett judged, BRK was too volatile.


If you
+ cannot afford to buy a BRK-US head stock; and/or
+ hold concentrated portfolios because of bandwidth or from trying to emulate Buffett or from thinking you are better than Buffett (perhaps as part of a positive mental attitude endeavour); and
+ seek to justify high concentration on the basis that this is what Buffett does....

1. Buffett would not advocate it.
2. You might wish to consider buying other stuff you know less well but think will likely go up over the longer term. You may, for example, believe in the concept of equities as having an equity risk premium...as Buffett does. It would lead you away from very concentrated portfolios.


Ok, that's it.

 

[Triathlete]

I think its clear there are many ideas out there about the ideal way level and method of diversification, I guess the best we can do is truly understand what we are trying to achieve with a specific type of diversification, consider all the unexpected results that may occour and choose a strategy that we are comfortable with in terms of personal investing philosophy, emotional type and risk management.

I agree with this statement Galumay....and this is the way I look at diversification presently.

 

[Triathlete]

Risk = volatility in this context.

You are exposed to market risk from the very first stock added to your portfolio. Depending on the stock, 'market risk' whatever that actually is, might be a relatively small portion of total risk. As you add more stocks, in general, volatility from market risk increases as a proportion of total portfolio risk. Total portfolio risk generally declines. The closer the portfolio effectively becomes to the 'market' in its composition, the less ability it has to outperform it as a tautology. Conversely, increasingly matching the index reduces the opportunity the portfolio has to underperform it too.

Number of stocks matters a lot less than the composition of the portfolio itself for all of the above statements. A portfolio with 200 stocks in from the ASX it can perform vastly differently to the ASX 200.

Thanks DeepState for your explanation on the topic.

 

[galumay]

....

Ok, that's it.

All of that is well reasoned and clearly articulated as usual, DS.

My only comment would be to suggest that we should still be wary of seeing diversification as a panacea, there will be opportunities and times in your life when diversifying is exactly the wrong thing to do, the least risk will lie with the most concentrated position. The incredibly difficult part is being able to recognise them and have the mindset to act.

We also have to remember the tradeoffs with high diversification, and make sure we have means to manage the attendent risks.

I think there is a tendency to look for quick and easy solutions in life, diversification sounds like one of them to a lot of investors.

 

[Triathlete]

thanks everyone for your feedback so far.

From my research, I found this study which shows that you need 38 Aussie stocks to achieve a diversified portfolio ...

You may have diversification with 38 stocks but what is the average return of a portfolio that size. It would be interesting to see some charts over a 12 month or longer period to see which way the stocks are moving.

You may fined that 1/3 are moving up in price maybe higher in a bull market .1/3 are moving sideways and 1/3 are moving down I would find it hard to believe that this would be the best way to generate the best returns on any portfolio.

Yes you still might have a dividend coming in but for me the first thing I always look for in any stock is capital growth the dividend is the icing on the cake.

I am still of the belief that you only want stocks moving up in the portfolio and get rid of any moving sideways for an extended period and those that are moving down to get the best returns for the portfolio ,off course this would be an actively managed portfolio.

The only time I would hold down trending stocks is if I was going to take a short position.

 

[luutzu]

My take away from Graham/Dodd, Fisher... Buffett probably got it from them too (or he might come to it independently):

If you don't know, or don't care to know, or have no interest in getting to know the individual business each of your stock holding represents... then diversify into an index fund. An index fund is cheap, it follows the market (it is the market)... and in the long term, the market (through the businesses it represents) generally do well.

So indexing, or diversification to the extent that it almost replicate the index, is cheap, does not consume much time and effort, does not require an active interests in the stock and the market... and over the long term will generally do well and are relatively safe.

BUT...

But if you do not index and want to buy individual stock - be that buying one, five, ten or thirty... what you are saying is this: I know what I am doing; I know why I chose stock A instead of the other 2000+ stocks; I know how much I'm expected to gain from each, and why, and when I would want to get out etc. etc....

In other words, when you start to be selective in your investing, you ought to be selective because you know why you select one stock over another.

Such knowledge and gahoonies implies, obviously, that you have a keen interest in the market and the businesses listed on it and know the good from the bad and the ugly - and select the good and avoid the bad just like Woolworths' "Select" homebrand is no ordinary home brand because it's "Select", by Woolworths

So, for most, say "99%", of investors... they ought to index because to do otherwise means this:

1. They have to be a business analyst; with knowledge and training that rivals one; OR
2. Get financial advice, from those knowledgeable advisors and their fine prints; OR
3. Be rich enough to be the chosen few worthy of "selective", "personal" and "private" management by the gurus and their 2/20, heads I win tails you lose, fee structure.

Since option 2 and 3 is not a good idea, the selective or enterprising investor must necessarily be 1 - the business analyst. And if your day job is not in finance and business, and you have no interests to learn the trade... probably best to index.


I thought such advice, while simple, makes sense.

To quote mother Benjamin Graham and David Dodd, to do average on Wall St is easier than it looks; to do slightly better is more difficult than it seem.

And I am definitely sure they, and Buffett, say those stuff before these "modern" theory of portfolio management and their Greek alphabet.

But you know, keep up the good work. I don't mind.

 

[Value Hunter]

Another issue is stocks as a percentage of overall investments and your diversification outside of stocks. Many investors including myself hold investments other than shares. My whole share portfolio is currently invested in one company - Credit Corp (CCP) but I have other investments apart from shares. This is an important factor which needs to be considered when discussing diversification in the share market.

 

[QuietGrowth]

Diversification through ETFs is preferable than through individual stocks (less expensive).

It is preferable if you invest in a risk-optimised portfolio that is customized for you, with the portfolio consisting of various low-cost index ETFs across different asset classes. The more the diversification of this global portfolio, the better. (For example, each of the 5 portfolios that our firm QuietGrowth offers, has 8 ETFs across different asset classes.)

Then you would need to constantly rebalance the portfolio whenever the drift of each of the ETFs in the portfolio becomes significant. Also, you would need to re-allocate the mix of your portfolio, whenever it is appropriate.

All this takes a fine amount of skill, knowledge and discipline, so it is difficult for everyone to put it into practice. However, this approach will give you better returns in the long-run compared to simply investing in few favourite index funds.

Dilip
QuietGrowth

 

[galumay]

All this takes a fine amount of skill, knowledge and discipline, so it is difficult for everyone to put it into practice. However, this approach will give you better returns in the long-run compared to simply investing in few favourite index funds.

QuietGrowth

Its not definitive, it MAY give you better returns. Thats all you can say with any certainty. Diversification is always a double edged sword, there are ample arguments against diversification for diversifications sake.

If you are good enough then your universe of companies invested in should be very small indeed - potentially just one. Its self evident this will maximise your returns - if you are good enough and have sufficient confidence in your skill!