What’s the right way to diversify? For me, the simple answer is that I don’t diversify. I own 5 stocks or fewer most of the time. But many investors want to diversify far beyond that. Are they doomed to hug an index? To waste a lot of effort they could save by handing their money over to Vanguard?
There are ways to diversify selectively. But first, let’s ask why you need to make sure you aren’t diversifying blindly.
There are risks in diversifying too much just as there are in diversifying too little. These risks don’t come from the number of stocks you own – but from lowering your selectivity.
Whether you want to own 5 stocks or 50 – you should have the same two goals in mind. You want to minimize risk while maximizing selectivity.
How can you do that?
The first step is to turn the concept of diversification inside out. You need to invert your framework. Rather than using an objective – portfolio focused – approach, you want to start with a subjective – investor focused – approach.
The enemy of selectivity is divided attention. That is the risk of diversification. In theory, we want to own as many stocks as possible – provided those stocks are close to equally good (given what we can know about them). Now obviously stocks are not equally good. The companies are not of equal quality. Nor are their prices equally cheap. That is where selectivity comes in.
There is also the issue of “what we can know about them”. This is a subjective issue. Not an objective one. In practice, we can know more about some stocks than others. Local stocks are more worthy of your attention than foreign stocks. Likewise, stocks in industries where you work are a good place to start.
As you study stocks you will develop a network of knowledge – what Warren Buffett calls a circle of competence – connecting companies you’ve already studied to their competitors, customers, suppliers, etc. So we must always be extra careful when venturing into sectors, industries, and even companies we are totally unfamiliar with. It’s best to diversify where a link – an intellectual bridge – connects this new stock to one you already know.
Stock selection does not happen on the individual stock level alone. It can be done in a lot of different ways. And they aren’t all strictly hierarchical. For example, some people choose countries to invest in first – and then companies within those countries second. Some people choose strategies to use (like net-nets, spin-offs, etc.) first and then pick stocks that fit in those pigeon holes second. Others are not so rigid. They take a little of this and a little of that. They know they like the stocks they buy. But they don’t always know what strategy they are following or even what lead them to the stock.
When worrying about diversification, it helps to be a bit rigid. Diversification is really just one part – though it tends to be the most talked about part – of risk control. If your overall strategy is risky or your individual selections are risky – the end result will still involve quite a lot of risk even if you own a lot of stocks.
I don’t like to stress this too much – because I don’t believe volatility is what we really mean when we say risk – but my own portfolio tends to fluctuate in price less than the overall market. There are several reasons for this. One is obviously because I tend to keep some cash much of the time. When comparing the returns of my account to the market – the market is treated as fully invested. So it’s an unfair comparison in terms of selection alone. The other aspect is the volatility of the stocks involved. For whatever reason, I tend not to own very volatile stocks. The end result is often a portfolio of about 5 stocks that moves a little less than the market – especially in bad quarters for the market. The flipside is poor relative performance in good times. My performance over the last year – twelve months, not year to date – is absolutely atrocious. I am up just a few percent. The market has done much, much more than that.
Obviously, the vast majority of investors – and probably everyone reading this article – will want to, and should want to, own more than 5 stocks.
How many should you own?
Ben Graham suggested “well diversified” meant 10 to 30 stocks. That was his theory. In practice, his hedge fund tended to own more like 100 stocks. However, the top positions were often 5% or more. The median position size was probably in the 1% to 2% size. Certainly, there is no reason for an investor to be more diversified than that. You never need to own more than 50 stocks.
On the one side you have people like Warren Buffett (and Charlie Munger and Phil Fisher) would rather own 5 than 50 stocks. On the other side you have Ben Graham who would certainly pick 50 stocks over 5 stocks.
Who is right? And who is wrong?
I think both sides are right. Subjectively right.
How diversified was Ben Graham’s portfolio really?
It depends on how you look at it. By number of stocks – it was very, very diversified. By strategies – it was very, very concentrated. Graham used only a couple strategies. And – over the years – he actually concentrated more and more on fewer and fewer strategies.
Ben Graham pruned his toolbox. Warren Buffett pruned his portfolio.
This is a question of the “level” of selectivity we are talking about. Warren Buffett likes to be specific stock selective. He could have bought both Coke and Pepsi (his results would’ve been fine in Pepsi) but he focused on Coke.
Sometimes Buffett was more scattershot. He bought a bunch of railroads at once (then focused on Burlington Northern). He bought a couple ad agencies (Ogilvy & Mather and Interpublic) and several media stocks (Washington Post, Knight-Ridder, Capital Cities, Affiliated, etc.) in quick succession. He also bought a basket of Korean stocks – maybe 30 or so – at once. Though he ended up building a much bigger position in Posco.
What about strategies?
Who had more strategies? Warren Buffett or Ben Graham?
Here they are pretty equally diversified. In the early years, Buffett used many of the same strategies as Graham:
· Special situations (especially announced events – like liquidations)
· Net-nets (stocks selling below their net current assets)
· Control positions (a large stake with a board seat, the possibility of a proxy fight, riding another activist’s coattails, etc.)
· Arbitrage
This pretty much sums up Ben Graham’s effective strategies. He tried some other tactics. They didn’t work so well. And they weren’t worth the trouble. He shorted stocks – “pair traded” – early in his career. It did not fit his character. It did make him nervous. And it seems to have hurt his returns rather than helped them.
There is another strategy Graham used. He called it “related hedges”. These involved shorting one security and buying another. The best example is shorting a common stock while buying the convertible preferred stock. We could count this as a separate strategy. And one particularly risky variation on this one – in the sense that the time frame for mean reversion was unlimited – was buying a stock that owned part of another publicly traded company while shorting the other company. You can find two examples of this approach in Graham’s memoirs (now out of print). One involved Guggenheim Exploration. The other involved General Motors and DuPont.
You can see that most of Graham’s strategies were closely related. The relation between them is process. Graham was a criteria based investor. He was not a holistic thinker. When it came to stocks, he thought in rules. He thought in checklists. Boxes that either were checked or were not.
This is a good approach for a wide diversifier. If you are picking stocks based on whether one or two rules are met – there is little additional gain to be had from trying to rank which of those stocks is best.
A stock either is or is not a net-net. It either is or is not trading at a discount to the sum of its publicly traded parts (closed end funds, holding companies, etc.). A company either is or is not trading for less than its value if a merger goes through (Graham even produced a formula for how to calculate whether you should buy into a merger or not).
This is rules based investment. And it works well with wide diversification.
Where can you practice rules based investing? How many different strategies can you use? How many countries can you invest in? And how many stocks can you own in total?
It’s a matter of attention. You don’t want to spread yourself too thin.
Most investors don’t need to split themselves in more than 3 directions at any one level of selectivity. In other words, if you can simply attend to:
· 3 strategies
· 3 countries
· 3 specific stocks that fit that strategy in that country
You can be well diversified. The result – of this specific example of a 3 by 3 by 3 approach – is 27 stocks. That would be a position size of 3.7%. In other words, if you made a big – but not complete – mistake in picking the stock and lost 50% of your investment, you’d lose a little less than 2% of your portfolio. This is a good way of thinking about diversification.
What 3 strategies work well:
· Net-nets
· Low EV/EBITDA
· Special situations
If you invest in micro caps at least as frequently as big caps – by micro caps I mean stocks under $100 million – you can use the first strategy (net-nets) all around the world. If you don’t – you can’t. You can substitute another asset based strategy like “sum of the parts” investing.
Basically, the 3 best – most different – value strategies to use are some form of:
· Asset bargains
· Earnings bargains
· Event bargains
I would add a fourth category – my favorite – and call it “franchise” or quality bargains. These are above average businesses trading at below average prices. They are the best way to make money in the long-run.
Any backtest that looks for the best stocks to have owned over the last 15 years (regardless of end point) will tend to turn up a list of quality companies. Quality here generally means recording profits each year – and especially – profits that result in an above average return on capital.
In other words, if you simply tallied up the number of years – over the last 15 – in which a company earned a return on capital above an acceptable level (I’d offer 10% to 15% return on equity with no leverage as being the hurdle to clear) the companies with the most tallies next to their names would tend to be the best long-term performers.
This is less true in the short-term. Price has a big influence on what will do well over the next 1 to 5 years. It has less influence over the next 10 to 15 years.
The less time you have as an investor – the more time you should spend on statistical bargains. The more you should buy Ben Graham stocks. With a solid process – honed into habit over the years – you can do well quickly using this approach. So, I’ll focus on the “value” rather than “quality” approach here.
If we took 3 years as our Goldilocks holding period – one which allows value strategies based on price to work well, but doesn’t require frequent trading – we have a formula for how to divide your attention.
Let’s say you need to find 27 stocks (3 strategies / 3 countries / 3 stocks). If you hold each stock for 3 years, you can take more than a month to pick each stock. That’s a good pace. I would never want to use an approach that required me to buy more than one new stock a month. That can lead to rushed and sloppy stock picking.
A lot of investors probably – through mutual funds especially – are diversified to the equivalent of 27 stocks. If you are, ask yourself not just how diversified are you – but also, how are you diversified?
Do you have 3 different strategies (or more) you can confidently carry out year after year. Do you have 3 countries (or more) where you feel comfortable parking your money year in and year out. And do you have at least 3 specific examples of each strategy in each country.
Or do you have a basket of clones?
Do you just own 20 different American blue chips?
If so, you may be diversified enough. But you may not be thinking enough about how best to keep your selectivity high while getting the diversification you want.
Here’s a good test to use. Do you own more than 3 stocks in the Dow?
If so, you aren’t being selective enough.
There are 30 stocks in the Dow. If you own more than 3 of them – you are “accepting” more than 10% of applicants from the pool of the very best known (and best covered) stocks in the world.
Now, if American stocks were particularly cheap and big caps particularly cheap– this might be fine. There is theoretically nothing wrong with owning more than 3 stocks from the Dow.
But there is something wrong with owning more than 3 stocks from the Dow and not knowing you have a strategy of buying big American blue chips.
If you own more than 3 stocks from the Dow, your portfolio is not in any sense random. If you ignored stock size completely, the chance of picking even one stock from the Dow in a 50 stock portfolio would be way less than 50%.
I’m not saying you should use an approach that is exactly as likely to pick a $50 million market cap stock as a $50 billion market cap stock. But, it’s important that you know that when you are fishing overwhelming in a certain pond – a blue chip strategy, and American bias, a big cap bias, etc. – you recognize that you are “defaulting” to those selections.
You are letting convention select for you.
You don’t have to do that. You can choose to diversify without forcing yourself to automatically accept certain strategies, countries, and stocks.
The most important of these – by far – is to avoid automatically picking a conventional strategy.
Most investors are not value investors. If you own any of the same stocks most investors do – you need to question whether or not you are following a value strategy or a conventional strategy.
Value investing is unorthodox. No matter how diversified your portfolio becomes – it must never become conventional.
The best objective measure of selectivity is convention.
A conventional portfolio is extremely unlikely to be the result of a selective process.
And a truly selective process is extremely unlikely to produce a conventional portfolio.
The well diversified ideal is owning a lot of uncommon stocks.
One, how many stocks do you own?
Two, how “rare” are those stocks?
Ben Graham’s portfolio had a lot of stocks in it. But not a lot of names you’d recognize.
Graham was always diversified – but never conventional
That’s the ideal to aspire to.
Talk to Geoff about Selectivity
There are ways to diversify selectively. But first, let’s ask why you need to make sure you aren’t diversifying blindly.
There are risks in diversifying too much just as there are in diversifying too little. These risks don’t come from the number of stocks you own – but from lowering your selectivity.
Whether you want to own 5 stocks or 50 – you should have the same two goals in mind. You want to minimize risk while maximizing selectivity.
How can you do that?
The first step is to turn the concept of diversification inside out. You need to invert your framework. Rather than using an objective – portfolio focused – approach, you want to start with a subjective – investor focused – approach.
The enemy of selectivity is divided attention. That is the risk of diversification. In theory, we want to own as many stocks as possible – provided those stocks are close to equally good (given what we can know about them). Now obviously stocks are not equally good. The companies are not of equal quality. Nor are their prices equally cheap. That is where selectivity comes in.
There is also the issue of “what we can know about them”. This is a subjective issue. Not an objective one. In practice, we can know more about some stocks than others. Local stocks are more worthy of your attention than foreign stocks. Likewise, stocks in industries where you work are a good place to start.
As you study stocks you will develop a network of knowledge – what Warren Buffett calls a circle of competence – connecting companies you’ve already studied to their competitors, customers, suppliers, etc. So we must always be extra careful when venturing into sectors, industries, and even companies we are totally unfamiliar with. It’s best to diversify where a link – an intellectual bridge – connects this new stock to one you already know.
Stock selection does not happen on the individual stock level alone. It can be done in a lot of different ways. And they aren’t all strictly hierarchical. For example, some people choose countries to invest in first – and then companies within those countries second. Some people choose strategies to use (like net-nets, spin-offs, etc.) first and then pick stocks that fit in those pigeon holes second. Others are not so rigid. They take a little of this and a little of that. They know they like the stocks they buy. But they don’t always know what strategy they are following or even what lead them to the stock.
When worrying about diversification, it helps to be a bit rigid. Diversification is really just one part – though it tends to be the most talked about part – of risk control. If your overall strategy is risky or your individual selections are risky – the end result will still involve quite a lot of risk even if you own a lot of stocks.
I don’t like to stress this too much – because I don’t believe volatility is what we really mean when we say risk – but my own portfolio tends to fluctuate in price less than the overall market. There are several reasons for this. One is obviously because I tend to keep some cash much of the time. When comparing the returns of my account to the market – the market is treated as fully invested. So it’s an unfair comparison in terms of selection alone. The other aspect is the volatility of the stocks involved. For whatever reason, I tend not to own very volatile stocks. The end result is often a portfolio of about 5 stocks that moves a little less than the market – especially in bad quarters for the market. The flipside is poor relative performance in good times. My performance over the last year – twelve months, not year to date – is absolutely atrocious. I am up just a few percent. The market has done much, much more than that.
Obviously, the vast majority of investors – and probably everyone reading this article – will want to, and should want to, own more than 5 stocks.
How many should you own?
Ben Graham suggested “well diversified” meant 10 to 30 stocks. That was his theory. In practice, his hedge fund tended to own more like 100 stocks. However, the top positions were often 5% or more. The median position size was probably in the 1% to 2% size. Certainly, there is no reason for an investor to be more diversified than that. You never need to own more than 50 stocks.
On the one side you have people like Warren Buffett (and Charlie Munger and Phil Fisher) would rather own 5 than 50 stocks. On the other side you have Ben Graham who would certainly pick 50 stocks over 5 stocks.
Who is right? And who is wrong?
I think both sides are right. Subjectively right.
How diversified was Ben Graham’s portfolio really?
It depends on how you look at it. By number of stocks – it was very, very diversified. By strategies – it was very, very concentrated. Graham used only a couple strategies. And – over the years – he actually concentrated more and more on fewer and fewer strategies.
Ben Graham pruned his toolbox. Warren Buffett pruned his portfolio.
This is a question of the “level” of selectivity we are talking about. Warren Buffett likes to be specific stock selective. He could have bought both Coke and Pepsi (his results would’ve been fine in Pepsi) but he focused on Coke.
Sometimes Buffett was more scattershot. He bought a bunch of railroads at once (then focused on Burlington Northern). He bought a couple ad agencies (Ogilvy & Mather and Interpublic) and several media stocks (Washington Post, Knight-Ridder, Capital Cities, Affiliated, etc.) in quick succession. He also bought a basket of Korean stocks – maybe 30 or so – at once. Though he ended up building a much bigger position in Posco.
What about strategies?
Who had more strategies? Warren Buffett or Ben Graham?
Here they are pretty equally diversified. In the early years, Buffett used many of the same strategies as Graham:
· Special situations (especially announced events – like liquidations)
· Net-nets (stocks selling below their net current assets)
· Control positions (a large stake with a board seat, the possibility of a proxy fight, riding another activist’s coattails, etc.)
· Arbitrage
This pretty much sums up Ben Graham’s effective strategies. He tried some other tactics. They didn’t work so well. And they weren’t worth the trouble. He shorted stocks – “pair traded” – early in his career. It did not fit his character. It did make him nervous. And it seems to have hurt his returns rather than helped them.
There is another strategy Graham used. He called it “related hedges”. These involved shorting one security and buying another. The best example is shorting a common stock while buying the convertible preferred stock. We could count this as a separate strategy. And one particularly risky variation on this one – in the sense that the time frame for mean reversion was unlimited – was buying a stock that owned part of another publicly traded company while shorting the other company. You can find two examples of this approach in Graham’s memoirs (now out of print). One involved Guggenheim Exploration. The other involved General Motors and DuPont.
You can see that most of Graham’s strategies were closely related. The relation between them is process. Graham was a criteria based investor. He was not a holistic thinker. When it came to stocks, he thought in rules. He thought in checklists. Boxes that either were checked or were not.
This is a good approach for a wide diversifier. If you are picking stocks based on whether one or two rules are met – there is little additional gain to be had from trying to rank which of those stocks is best.
A stock either is or is not a net-net. It either is or is not trading at a discount to the sum of its publicly traded parts (closed end funds, holding companies, etc.). A company either is or is not trading for less than its value if a merger goes through (Graham even produced a formula for how to calculate whether you should buy into a merger or not).
This is rules based investment. And it works well with wide diversification.
Where can you practice rules based investing? How many different strategies can you use? How many countries can you invest in? And how many stocks can you own in total?
It’s a matter of attention. You don’t want to spread yourself too thin.
Most investors don’t need to split themselves in more than 3 directions at any one level of selectivity. In other words, if you can simply attend to:
· 3 strategies
· 3 countries
· 3 specific stocks that fit that strategy in that country
You can be well diversified. The result – of this specific example of a 3 by 3 by 3 approach – is 27 stocks. That would be a position size of 3.7%. In other words, if you made a big – but not complete – mistake in picking the stock and lost 50% of your investment, you’d lose a little less than 2% of your portfolio. This is a good way of thinking about diversification.
What 3 strategies work well:
· Net-nets
· Low EV/EBITDA
· Special situations
If you invest in micro caps at least as frequently as big caps – by micro caps I mean stocks under $100 million – you can use the first strategy (net-nets) all around the world. If you don’t – you can’t. You can substitute another asset based strategy like “sum of the parts” investing.
Basically, the 3 best – most different – value strategies to use are some form of:
· Asset bargains
· Earnings bargains
· Event bargains
I would add a fourth category – my favorite – and call it “franchise” or quality bargains. These are above average businesses trading at below average prices. They are the best way to make money in the long-run.
Any backtest that looks for the best stocks to have owned over the last 15 years (regardless of end point) will tend to turn up a list of quality companies. Quality here generally means recording profits each year – and especially – profits that result in an above average return on capital.
In other words, if you simply tallied up the number of years – over the last 15 – in which a company earned a return on capital above an acceptable level (I’d offer 10% to 15% return on equity with no leverage as being the hurdle to clear) the companies with the most tallies next to their names would tend to be the best long-term performers.
This is less true in the short-term. Price has a big influence on what will do well over the next 1 to 5 years. It has less influence over the next 10 to 15 years.
The less time you have as an investor – the more time you should spend on statistical bargains. The more you should buy Ben Graham stocks. With a solid process – honed into habit over the years – you can do well quickly using this approach. So, I’ll focus on the “value” rather than “quality” approach here.
If we took 3 years as our Goldilocks holding period – one which allows value strategies based on price to work well, but doesn’t require frequent trading – we have a formula for how to divide your attention.
Let’s say you need to find 27 stocks (3 strategies / 3 countries / 3 stocks). If you hold each stock for 3 years, you can take more than a month to pick each stock. That’s a good pace. I would never want to use an approach that required me to buy more than one new stock a month. That can lead to rushed and sloppy stock picking.
A lot of investors probably – through mutual funds especially – are diversified to the equivalent of 27 stocks. If you are, ask yourself not just how diversified are you – but also, how are you diversified?
Do you have 3 different strategies (or more) you can confidently carry out year after year. Do you have 3 countries (or more) where you feel comfortable parking your money year in and year out. And do you have at least 3 specific examples of each strategy in each country.
Or do you have a basket of clones?
Do you just own 20 different American blue chips?
If so, you may be diversified enough. But you may not be thinking enough about how best to keep your selectivity high while getting the diversification you want.
Here’s a good test to use. Do you own more than 3 stocks in the Dow?
If so, you aren’t being selective enough.
There are 30 stocks in the Dow. If you own more than 3 of them – you are “accepting” more than 10% of applicants from the pool of the very best known (and best covered) stocks in the world.
Now, if American stocks were particularly cheap and big caps particularly cheap– this might be fine. There is theoretically nothing wrong with owning more than 3 stocks from the Dow.
But there is something wrong with owning more than 3 stocks from the Dow and not knowing you have a strategy of buying big American blue chips.
If you own more than 3 stocks from the Dow, your portfolio is not in any sense random. If you ignored stock size completely, the chance of picking even one stock from the Dow in a 50 stock portfolio would be way less than 50%.
I’m not saying you should use an approach that is exactly as likely to pick a $50 million market cap stock as a $50 billion market cap stock. But, it’s important that you know that when you are fishing overwhelming in a certain pond – a blue chip strategy, and American bias, a big cap bias, etc. – you recognize that you are “defaulting” to those selections.
You are letting convention select for you.
You don’t have to do that. You can choose to diversify without forcing yourself to automatically accept certain strategies, countries, and stocks.
The most important of these – by far – is to avoid automatically picking a conventional strategy.
Most investors are not value investors. If you own any of the same stocks most investors do – you need to question whether or not you are following a value strategy or a conventional strategy.
Value investing is unorthodox. No matter how diversified your portfolio becomes – it must never become conventional.
The best objective measure of selectivity is convention.
A conventional portfolio is extremely unlikely to be the result of a selective process.
And a truly selective process is extremely unlikely to produce a conventional portfolio.
The well diversified ideal is owning a lot of uncommon stocks.
One, how many stocks do you own?
Two, how “rare” are those stocks?
Ben Graham’s portfolio had a lot of stocks in it. But not a lot of names you’d recognize.
Graham was always diversified – but never conventional
That’s the ideal to aspire to.
Talk to Geoff about Selectivity
