Minor Axiom 1: Always play for meaningful stakes.
Minor Axiom 2: Resist the allure of diversification (I see your stunned look)
Three flaws regarding diversification:
- It forces you to violate the precept of Minor Axiom I - that you should always play for meaningful stakes.
- By diversifying, you create a situation in which gains and losses are likely to cancel each other out.
- By diversifying, you become a juggler trying to keep too many balls in the air at once.
As we work through these axioms, we'll see that they will violate much of what you've learned. Understand that my posting these is not an endorsement (and I'm not qualified to endorse anything but a check made payable to me) but rather a chance to explore an interesting view of risk/reward.
5 comments:
The tenant of limiting your diversification is actually not that far beyond the pale. Given that most people only have time to be familiar within a limited number of investment areas it makes sense. The idea is to do very deep due diligence on a handful of investments and place your money on your most certain options. It is highly unlikely that you are going to find more then a handful of really good bets in any case.
So if you are only likely to come up with a very limited number of "good ideas" why would you spread your money around.
This philosophy also avoids the mathematical phenomena known as gamblers ruin by limiting the number of bets. Gamblers ruin postulates that if a party makes a series of bets of the same size against a house with what is effectively unlimited resources (the market), that if they play long enough the gambler will have to go broke: even if their odds of winning each "bet" is 90%. Portfolio management theory is also supposed to avoid this problem, but does so at the cost of the before mentioned offsetting loses and gains.
Because of the lose aversion that their clients generally have, this philosophy of concentration is for practical reasons off limits to portfolio managers, etc.
As I noted before it would work particularly well with a style of investing that pays back on its DD (like value investing or possibly real estate).
Russell, you make very good points.
Out in the real world, I recently had a portfolio of about 60 stocks; couldn't keep track of 'em. I had some great winners, but I didn't always realize that some choices were stalled, doing poorly and/or should have been culled.
I'm beginning to think of money as fungible. In other words, I don't care WHERE or HOW I make my returns (other than honestly, of course!), only THAT I make my returns. Belief in diversification was my bane.
My goal today: to have a small, concentrated portfolio. I'm down to 20 stocks, two mutual funds, and two ETFs for a little better than half of my portfolio. Even fewer positions would be better from my point of view; I'm struggling to get there. The rest of my portfolio -- nearly 50% -- is in short term bond funds or cash.
Now as for applying the money-is-fungible concept:
A very good stock for me, Royal Bank of Canada (RY), has been declining recently, something I notice only because now I have 20 positions -- not some 60 -- to monitor.
Since over many years RY has been a very good performer albeit with periods of retracement, I'm viewing the current possible retracement as a possible buying opportunity. So I'll apply Minor Axioms 1 & 2 ("Always play for meaningful stakes"; "Resist the allure of diversification") -- and buy more.
Some will argue that by buying more RY, I will have "too much." Not I. I call it having a "meaningful stake"!
~ Nona
PS: Nice yield for RY, btw: just a notch under 3% currently. But will be higher if RY declines further. What's more, the company is good about raising the dividend regularly.
First, thanks for jumping in the discussion.
Nona, regarding money as fungible....I think that most people don't think of it that way. James Altucher on TSC mentioned the following. A model had just received $500K for a modeling engagement and asked what she should do. His response...go out and get another modeling engagement! So if my portfolio is sitting safely in a bank or bonds whatever and I earn money working, you could call that a "return". My principal sits someplace risk free, but my salary earns the overall return. So I would modify your comment slightly to say...all income is fungible as a "return".
On Diversification: I tend to agree with this one. A portfolio of 20 stocks is diluted and returns accordingly. I think that if you are going to have that many stocks, then buy a mutual fund.
If you are going to have concentration, then I think that you have to have knowledge of macro and technical factors--meaning you have to manage your risk as Russell so aptly notes.
Against the Gods, the History of Risk Taking (Bernstein) was a good introduction to risk. I've picked up (again) Pompian's book on behavioral finance which has a nice exposition of all of the "stupid" stuff we're hard wired to do.
A wise man told me that 20 positions, according to the quants, represents diversification. If so, then by definition, my portfolio is not concentrated. But here's the other problem/challenge: selling some of my current positions means an immediate, guaranteed, no-doubt-about-it 15% haircut. (Long term cap gains.)
So you're right: 20 + positions is diluted. But look at it this way: I've come a long way, baby!
It will take a while to get out of my diversification mess. Bit by bit, when there are sound reasons to sell, I'll cut back some of the companies that I hold.
I don't want to be a trader. My goal is to be a (mostly) buy and hold investor, making only occasional changes but always buying when there are (temporary)declines that affect all companies, including the good ones, some of which I hope to have in my portfolio.
I look for companies that steadily grow their earnings and increase their dividends. If they do those two things, the price generally takes care of itself.
Thank you for your comments. And I'm always open to learning more, so criticism and correction is always welcome.
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