I hate diversification – not as much as Justin Bieber, but it’s pretty close.
In my opinion it does nothing more than set your portfolio on the road to mediocrity. Might as well put your money into index funds and double down on the cocktails with the brokerage that you’ll save.
Remember back to when you first embarked on your apprenticeship in the markets. They told you not to “put all your eggs in one basket”. If you visit any modern day financial planner or full service broker these days you’ll walk away with a nicely balanced portfolio, consisting of a variety of asset classes. Some stocks, mutual funds, bonds and maybe some precious metals, if you’re lucky. I do hope there’s some cash in there as well.
What stocks you ask? Hmmm, let me see. Blue chips, of course. Some tech issues and a few industrials for good measure. Rounded out with a handful of high dividend payers. A more astute player might move you into some ETF’s (hopefully not double and triple leveraged ones).
When it comes to bonds there’s Muni bonds, junk bonds and treasuries. Might as well cover your
ass bases and grab some of each, just to be sure. By the time you’re finished you’ve got yourself a basket of assets that will help your broker with a down payment on their next yacht.
How many of each do we need? That’s a tricky one. As far back as the bible King Solomon thought seven or eight was enough. Then the heavy hitters of modern portfolio theory (Markowitz, Elton, Gruber et al) came along and started producing models of risk vs expected return.
Fifteen became the common number touted. Any more than that wasn’t beneficial to improving overall returns, we were told. Who can manage fifteen different investments? Late mail. A paper published in the Journal of Financial and Quantitative Analysis (Vol. 22 No 3, September 1987) debunked this, concluding that “We have shown that a well-diversified stock portfolio must include, at the very least thirty stocks..”.
Where does that leave you? Will those thirty stocks cushion the fall when your quote screen is a sea of red? A little, if you’re lucky.
Let’s step away for a moment and take a look at the food industry. The WSJ reported back in 2014 that Mcdonalds (NYSE:MCD) had in excess of 100 menu items, and if anyone ordered a McWrap the kitchen imploded. The company had become bloated and it was reflected in the stock price.
‘In-n-Out’ Burger, on the other hand, only has a handful of items and a cult like following. You do the math.
Maybe it’s just the fast food industry? What about regular restaurants? . I’ve been known to enjoy dining at a nice restaurant when I have a few dollars burning a hole in my pocket . Then the menu arrives, it’s the size of a small book and it takes me 20 minutes to decide on an appetizer.
Gorden Ramsey, who doesn’t mince his words, remarked in one episode of the TV series ‘Kitchen Nightmares’ that “A good restaurant does one sort of food brilliantly, a bad one does 50 badly.” You want to argue with him? Go on, I dare you!
In recent years, the development of software has been turned on it’s head with the creation of ‘agile’ processes and teams. Pop quiz. How many Apple (NASDAQ:AAPL) products can you think of that contribute fat stacks to their bottom line right now? A couple, right.
Instagram founder Kevin Systrom wanted his app to solve three problems. Three. Not twenty. Not ten. Just three. Facebook ended up buying the company two years later for approximately $1 billion in cash and stock. Not bad, eh?
I’m seeing a pattern here. Less is more, folks. It’s the same with stocks. Want to outperform the index? You need fewer stocks in your portfolio. Don’t trade stocks? Fewer assets. Fewer positions. You get the picture.
Let me tell you why – it’s the size of your outliers (both good and bad) that will determine your absolute return. You don’t need to know about ‘fat tails’ or skewness, just this – you want to hit a home run with one of your holdings, and maybe a base hit with a couple more. That’s it – the keys to the kingdom.
Under no circumstances can you ‘lose your shirt’ on any. Unforgivable. A flesh wound here and there is par for the course. We all have them, don’t worry.
Sound familiar? It should, they call it letting your profits run and cutting your losses.
Here’s my suggestion. Grab a piece of paper and write down your best ten ideas. No more than ten. Think about them for a day or so and come back and scrub five of them off the list. Gone. Look at those five remaining ones very carefully. Do they all deserve a place in the starting lineup? Maybe one or two of them get benched.
Now we’re talking. Make sure you do your research carefully, a critical component, as you need to truly believe in those remaining gems that you have unearthed. This starting five ain’t going to take a dive.
You, my friend, are now looking at an agile portfolio that has a good chance of outperforming the market. Despite what they say, put all those eggs in one basket. Just never take your eyes off them, and be ruthless if things turn pear shaped.
Enough from me. Time to get out of the bath (something I picked up from watching Trumbo) and check the Bloomberg.
Amos cut his teeth on the trading floors of Singapore and Sydney in the heydays of the early 90’s. Bond traders to the left of him, Option traders to the right. He now spends his time perfecting the art of cooking steak and one day hopes to meet Nassim Taleb.
He will be writing exclusively for Equity.Guru