Diversification

The Diverse Nature of Diversification

There are a number of benefits to being a private investor of modest means.  You have greater liquidity.  You can sell in and out of positions with little to no trouble.  You’re not beholden to your investors.  Small positions can drastically improve the performance of your portfolio.  And performance targets, if you have them, are set by nobody but yourself.  Absolute return investing at its finest.  I’m happy with all of that.  But one area I struggle with is diversification.

Diversification within Equities

This article is going to be somewhat of a contradiction.  With regard to investment as a whole, I am drawn to the concept of a portfolio diversified across different asset classes.  But when it comes to equities specifically, I agree with many of the greats who have spoken on the subject:

The appeal of a concentrated portfolio is that it is the only chance an investor has to beat the averages by a noteworthy margin” – Frank Martin

 

For an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities. Many people would consider that to be a relatively highly concentrated portfolio. In our view you want to own the best 10 or 15 businesses you can find, and if you invest in low leverage/high quality companies, that’s a comfortable degree of diversification.” – Bill Ackman

 

Our investment style has been given a name – focus investing, which implies ten holdings, not one hundred or four hundred” – Charlie Munger

In the book ‘Modern Portfolio Theory and Investment Analysis’, authors Edwin J. Elton and Martin J. Gruber found that beyond a certain number, stock diversification became negligible.  A portfolio of 20 stocks reduced the standard deviation of the portfolio as a whole to 20%.  Owning stocks beyond 20, and all the way up to 1000, further reduced it by only 0.8%.  Once you hit 20 stocks, you’re just about as diversified as you can be.

So far, so good,  I hold 18 companies in my portfolio, which is about the sweet spot for me.  I can manage that number in my spare time.

Diversification Without Equities

The issue I have is that my portfolio is entirely equity based.  Not only that, but just over three quarters are UK-listed.  Yes, there’s an ETF in there, but that is focused on European Emerging Market stocks.  More equities.  I’d hazard a guess that many of you reading this will be in a similar position.  My problem (OK, one of my problems) is that I occasionally view my portfolio as if it is much larger than it actually is.  Yes, I am diversified in some sense when it comes to equities, but what about all the other asset classes out there?  What is going to give me the best risk-adjusted return for the 40+ years I have ahead of me?

If you haven’t already read Meb Faber’s Global Asset Allocation (Kindle version currently £1.99 on Amazon), I’d highly recommend it.  Faber takes a look at the portfolios of large and successful money managers, including Mohamed El-Erian, David Swensen and Warren Buffett, specifically their weightings across 13 different asset classes:

Diversification
Source: Global Asset Allocation – Meb Faber

Do you see the problem with treating a £20k portfolio like it was £2bn in size?  Splitting a modest portfolio 13 ways makes each piece of the pie rather small.  Almost insignificant, in fact.  Now granted, El-Erian only invested in eight of these assets.  Swensen only six.  Buffett only recommended two!  (90% in the S&P 500, 10% in short-term govt. bonds).  But these are some of the most concentrated portfolios in the book.

This simplifies matters as well.  Looking at the latest report from the Yale University Endowment, 14.7% of the portfolio is allocated to leveraged buyouts.  16.2% to venture capital.  An investor with £20k isn’t going to get far with either asset area.  Harvard’s Endowment recently agreed to sell 8,500 acres of dairy farms.  How many cows can I buy with £1,000?  And where would I put them?  Even though diversification across asset classes will in all likelihood reduce volatility and smooth out returns, it feels ridiculous to me to allocate such small sums to each type of asset.

In truth, the options available to a private investor are, by and large, limited when compared to larger organisations.  We do at least have the growing ETF and REIT space to help meet some of our diversification needs, and for a low annual fee can obtain exposure to commodities, government & corporate debt, and property.  As I see it this is the only way for a small private investor to incorporate these into his or her portfolio.

Diversification in the Future

The argument against all this is that the Yale Endowment fund is $25 billion in size.  The Harvard Endowment is even bigger, at $37.6 billion.  It is therefore one thing to make a fortune, and another to preserve it.  Funds of these size simply have to be well-diversified to help ensure predictable and consistent returns.  The greatest returns over time, however, have come from equities, and this will no doubt be the case for the foreseeable future.  It therefore makes sense for someone who is seeking to grow their portfolio that they allocate most, if not all of it to stocks, particularly if they have a long time horizon.

Over time I hope for my portfolio to grow.  I understand that the best way to do this is via a concentrated, equity based allocation.  But that will not stop me thinking about ways in which I can bring alternative assets into play in the years to come.

And if you want true equity diversification, just put it all in the Vanguard Total World Stock ETF, with a holding of over 6,300 equities worldwide.  But where’s the fun in that?

Happy investing!

 

Leave a comment below, or find me on Twitter @BritishInvestor.

2 thoughts on “The Diverse Nature of Diversification”

  1. Chriss, Its a great idea and a great article, all serious investors should consider diversification, plus risk on holdings, the difficulty is weightings , its fiendishly difficult as an equity investor coping with balancing sector allocations again to achieve only minor diversification , considering three simplistic choices , cash( fails the inflation test) bonds (counter cyclical and just about beat inflation) or equities (More risks to happiness) is considerably difficult but I agree with you that with a larger fund it would be counter productive not to consider diversification . My preferred solution hold investment trusts and check the management is achieving growth over extended periods of time ( market upsets included).

  2. Interesting article. Thanks for sharing. You are right at about 20 holdings; I think any more needs alot of time to manage. I started off with unit trusts, but got back into equities because you don’t get the growth you can get from individual companies. So my investments are split between my share holdings and unit trusts. I did remember Warren Buffet saying trusts are perfect for the casual investor who doesn’t want to spend the time managing a share portfolio, and this is very true, but you wont get stellar returns unless you research companies and put money into those on good growth.

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