The stock market has taught us an important lesson these last few days: There are risks you can remove from owning stocks and risks you can’t. No matter how diversified you are – you can’t remove the risk of experiencing a paper loss of 5% or 10% within a few days or weeks. That risk will always be there. Does that mean you shouldn’t diversify?
I don’t diversify. My approach is to try to own about three to five stocks at once. I don’t recommend that approach to everyone. In fact, I don’t think most people are made for the kind of investing. So, I think diversification does make a lot of sense. But, diversification can’t do what a lot of investors want it to do.
Owning 50 stocks instead of five stocks or even 30 stocks instead of three stocks is not going to help you avoid seeing days where your portfolio is down 5% or 10%. Why? Because those kinds of losses tend to happen when stocks are down just because they are stocks. If you wanted a portfolio that wasn’t down as much as the Dow was this Monday – the way to do that (if you were only going to own stocks) would be to own very few stocks rather than very many. You’d actually have a better chance of being down a small amount if you owned 3 stocks instead of 50 stocks. This is just because owning very few stocks gives you better odds of moving in a way that’s different from the market. You’d also have a much better chance of being down on days the market wasn’t down. But, I’m not recommending you own three stocks instead of 50 stocks. Rather, my advice is just to accept that – if you are going to be 100% in stocks (which I think you should be) – then you aren’t going to be able to remove the risk of big, sudden paper losses. There will be weeks where you lose a lot of money. And that’s going to be the case if you own three stocks or 300 stocks. It’s true that you’ll have fewer weeks with big drops if you own 50 stocks than if you own five stocks. But, the really big drops in any stock tend to happen when just about everything is falling at the same time. So, a lot of diversification may help you avoid a few more down weeks. But, it’s not likely to cure the problem that most worries you – which is really big down weeks.
Diversification can remove business risk easily. For example, my portfolio has a ton of specific business risk in it. I own a stock called NACCO (NC). It has a customer that accounts for probably one-third of its business. In one day, NACCO could lose that customer and I – because there have been times where NACCO is 50% of my portfolio – could lose 15% of the intrinsic value of my portfolio in a single day (50% of 30% is 15%). If you don’t diversify, the loss of a single client at one of your businesses can hurt you. If you do diversify, it can’t. But, there are other ways of eliminating this risk. For example, if you buy Omnicom (OMC, Financial), which is just one stock – no client will account for more than about 3% of that company’s revenue. So, the loss of Omnicom’s biggest client would – even if you had 50% of your portfolio in Omnicom – cost you less than 2% of the intrinsic value of your stock portfolio (50% of 3% is 1.5%). So, diversification does eliminate customer concentration risk. But, simply choosing stocks with a large number of small customer fixes this problem just as well. What about business risk? This can be solved through diversification. So, you can own Omnicom and Interpublic (IPG) and WPP and Dentsu and Havas instead of just owning Omnicom. But, I don’t think that really does anything in this case. For example, Omnicom actually consists of three of probably the 10 biggest ad agencies in the world. Those agencies are mostly run separately. They’re just under the same corporate umbrella. So, I see no need to diversify across many ad agency stocks to avoid business risk. You can own more than one ad agency by owning just one stock.
But, there could be “corporate” risk even where there isn’t business risk. For example, there’s little business risk in owning Berkshire Hathaway (BRK.B, Financial). Berkshire owns a bunch of stocks in different industries. Funds are generated through insurance operations. And these funds either go into that stock portfolio or into businesses like utilities, railroads, industrial companies, etc. Berkshire doesn’t have customer concentration risk. Nor does it have business concentration risk. So, losing a client or failing in some specific business isn’t a risk in owning just that one stock.
But, should you put 100% of your net worth in Berkshire Hathaway?
Is that as safe as putting 100% of your net worth in an index fund?
There’s still corporate risk. Berkshire has one board of directors, it has (mainly) one capital allocator ( Warren Buffett (Trades, Portfolio)), much of the company’s debt (though not all) is guaranteed by the parent company. So, the company’s financial strength and its top management is non-diversified. Buffett (Trades, Portfolio) and Ajit Jain, head of insurance operations, are only two people, yet they account for a lot of key decisions at the company. I think most of us wouldn’t have any problem betting on them. But, we might want to diversify that bet a bit. So, you could make Berkshire 20% or 33% of your portfolio (that is, have a five-stock or three-stock portfolio) to diversify down this “corporate” risk. Obviously, the S&P 500 consists of 500 different corporations. And none of them account for more than like 4% of an S&P 500 index fund. The “corporate” risk at Apple (AAPL) might only put 4% of an S&P 500 index fund at risk. A portfolio that was 20% Berkshire Hathaway would mean that corporate risk at Berkshire Hathaway would put 20% of your portfolio at risk. That’s five times more corporate risk than you have with an index fund being 100% of your portfolio.
With Berkshire, you might risk it. But, still, even a conglomerate might be too risky to own just one of. Now, if you could own five conglomerates that might be enough. But, are there really fie conglomerates at any one time that are good enough and cheap enough to own?
You can never be completely certain of the management or the finances of a company. So, even if you focused on Buffett (Trades, Portfolio)-level managers and triple-A type companies – you might still want to diversify a little.
Then there is the “asset risk” or the “market risk” in owning stocks. This is at once one of the toughest risks to remove and also one of the easiest. If we are measuring over very short-term periods – like what a stock does today, this past week, or this past month – there’s nothing you can do about this kind of risk. You can’t remove it. And you can’t diversify it away. You could own other assets besides common stocks – but the cost of doing that (in terms of the compound annual growth rate drag over your investing lifetime) is simply too great. Yes, people do own mixed portfolios of stocks and bonds. Some people have mixed portfolios of long-term bonds, common stocks, cash and gold. That would be a very diversified portfolio in terms of asset class risks. But, it’s not a good portfolio. It will underperform a 100% stock portfolio in the long-run. The reason for adopting such a portfolio would be if you can’t really trust yourself to stay 100% in stocks. Otherwise, all you gain from that kind of diversification is a smoother, slower ride to less wealth at the end.
But, what about over the longer-term? Do all stocks really move together over the longer term? Or, are there other ways to diversify within stocks?
The reason stocks outperform other asset classes has to do with the inherent economics of a business. A successful business grows each year and is profitable each year. It does both. So, there is profit to be harvested (dividends, share buybacks) and there is growth that means dividends and share buybacks can be greater next year than last year. The same thing is true of timberland. So, we’d assume that assets like stocks and timberland outperform other assets like bonds and gold. Stocks and bonds can both suffer from inflation. But bonds offer a harvest with no growth while stocks offer a harvest and growth. Gold and timberland are real assets. But, gold doesn’t grow. To profit from it, you have to use enough of it that you end the year with less gold than you started the year. Timberland doesn’t work that way. You could harvest trees and still end up with as many trees as you had previously.
Now, any of these advantages can be offset by the “handicapping” mechanism of the market. There is some price – and it’s been reached before – where some bonds can be more attractive than some stocks.
We’re not at that point now. As I write this, the 30-year U.S. Treasury Bond yields 3.07% and Omnicom common stock yields 3.25%. So, that’s an 18 basis point advantage for Omnicom common stock over U.S. Treasury bonds and then Omnicom usually spends more on share buybacks than dividends. So, that’s – at a minimum – about a 3.25% cash yield plus a 3.25% “payment in kind” (you own more of the stock). That’s a 6.5% return. If the company as a whole grows profit by just 3% to 4% a year – then, you’re up to a 10% annual return in Omnicom stock versus a 3% annual return in the 30-year bond. It doesn’t matter how much of a “diversifier” that 30-year Treasury bond is to your portfolio. It’s not worth it. An expected annual return gap that big is going to prove way too costly over the long-run. Accepting such a huge annual drag is irrational. Only someone who values a smooth ride much more than a ride that gets you to a higher plateau 10, 20, 30 years from now would ever go in for a deal like that.
Yes, the bond diversifies you in a big way. But, it’s far too expensive a method of risk removal in the long run. Don’t buy bonds to remove risks. There are usually other, cheaper ways to try to remove a risk. For example, you may not be sure of Omnicom’s future – but you can be sure of the future of the five biggest ad agency holding companies combined. So, put 20% of what you’d put into Omnicom into each of them. There’s some cost to that diversification (I think Omnicom’s a bit cheaper and a bit better than some of its peers). But, it’s a very cheap form of risk reduction versus buying a Treasury bond.
What are other cheap ways to diversify within the asset class of stocks?
Most stocks are hurt by higher interest rates in the sense that higher interest rates usually coincide with lower P/E ratios. So, the price multiple on the same earnings per share usually contracts causing a stock’s price to grow less than its earnings when rates are rising. So, instead of looking to have 65% of your portfolio in stocks and 35% of your portfolio in bonds or something like that – why not think about having 35% of your portfolio in stocks that benefit from higher interest rates? This is only a partial offset. Even stocks where earnings rise with higher interest rates still experience the P/E multiple contraction problem. But, finding banks that have cheap deposits is a good way to pack your portfolio full of stocks that should hold up better when interest rates rise.
Inflation hurts all stocks. It hurts bonds too. Some people think stocks perform well during inflation. That’s not true. They just lose less of their value than bonds. Even stock that can raise prices in line with inflation often have some tangible capital requirements that become problematic.
As a rule, you probably want to own as many stocks as possible that handle inflation well. Why? Because simply by owning stocks you are exposing yourself to inflation risks. All stocks get hurt by inflation. But, Omnicom gets hurt a lot less than Union Pacific (UNP). Railroads and supermarkets and things like that do badly during periods of inflation because they have to replace tangible assets in today’s dollars. Companies with almost no net tangible assets in the business – like ad agencies, some software companies, etc. – handle inflation better. More importantly, these stocks don’t do worse in terms of long-term annual returns versus other stocks. So, this is a form of risk removal – you’re removing some inflation risk from your portfolio – that literally costs you nothing (most of the time). Right now, for example, you can easily sell a railroad stock you own and replace it with Omnicom without paying up. The ad agency doesn’t have a higher P/E than the railroad right now. So, that’s the kind of risk removal to consider.
There are two other obvious ways to remove risks. One is to own stocks outside your home country – or outside whatever country you mostly invest in (I know some investors in small countries who actually have more money in U.S. stocks than in their home country).
I don’t do enough of this. But, if you own stocks in the U.S., Canada, Japan, Australia, the U.K. and continental Europe all at the same time, your portfolio will be diversified in a way that doesn’t have to reduce your long-term return expectations. A great business in the U.K. has the same long-term return potential as a great business in the U.S.
The diversifying-by-country approach can be combined with the last risk removal technique: buying cheap stocks. So, the biggest risk to stocks as an asset class is that they get overpriced as a group sometimes. They’re overpriced right now.
But, that doesn’t mean all stocks all over the world are overpriced. The U.K. market is cheaper than the U.S. market right now. Let’s say you like car dealers as a business. You’re an American. You see Berkshire Hathaway bought a chain of car dealerships. Buffett thinks it’s a good industry with a moat. You want in.
What do you do?
Your best bet isn’t to buy publicly traded U.S. car dealerships. Why not?
One, as an American you probably already own a ton of U.S. stocks. What you own is denominated in U.S. dollars. The companies in your portfolio earn money in U.S. dollars.
Instead, look at U.K. car dealerships.
They earn their money in pounds. And – here’s the important one – they’re cheaper. As a group, U.K. car dealers are much, much cheaper than U.S. car dealers. So, if you are going to invest in a car dealer – make it a British car dealer.
For an American investor, this kills two risky birds with one stone. The risk of having all your money in businesses that earn their money in dollars is lessened. You now own some stocks that produce earnings in pounds. And the price of U.K. car dealers is often 50% cheaper on various earnings metrics than U.S. car dealers. So, your price risk is lower.
The one thing to check is to make sure the long-term return potential of the business itself – the return on equity – is as good at the U.K. car dealers you find as it is at many U.S. car dealers.
I think you can find some U.K. car dealers that are a better buy. If you don’t know the group well, you can diversify across five publicly traded U.K. car dealers instead of just one.
So, instead of putting 25% of your portfolio into say Vertu Motors, you put 5% into Vertu and 5% into four of Vertu’s peers. You are still betting a big part of your portfolio on: the U.K., car dealerships and cheap stocks (remember, U.K. car dealers are cheaper than U.S. car dealers).
That’s the kind of diversification – and the kind of risk removal – that makes sense.
What you want to find is ways of removing risks without lowering the long-term rate of compounding in your portfolio. Don’t do the conventional kind of diversifying. Don’t own some Treasury bonds. That is such an awful anchor to attach to your portfolio and have to lug around for decades. It’s just too expensive to try to reduce risk that way. It’s irrational to be so eager to reduce risk that you ensure you enter retirement with less wealth than you would have had using a less conventional, but still conservative approach.
There is nothing wrong with being 100% in stocks 100% of the time. But, you will have to be a little more pro-active in finding ways to remove risks while still staying in businesses that compound their value at good rates for a long time.
Use my example of buying a basket of U.K. car dealers as the model of risk reduction to strive for.
Diversify by country and by company. But don’t sacrifice stock cheapness or business quality to do it. Those two factors are paramount in every investment move you make. Always insist on getting a high quality business at a low stock price. Any diversifying move that doesn’t fit those two criteria is a bad decision.
Disclosures: Geoff owns NC, CFR and BWXT.