Diversify. Diversify. Diversify.
It’s one of the key concepts for investors to understand.
Most are familiar with the adage “don’t put all your eggs in one basket”, and diversification is essentially the same concept.
We’re not dogmatic about investors needing to own certain asset classes. Some of those asset classes have been dogs for years in terms of performance, and if the fundamentals don’t make sense we won’t own them. That willingness to spurn unattractive asset classes has actually been a differentiator for us with some prospective clients. Why own something likely to have lousy returns relative to other available assets just on the claims of “diversification”? Cash always has a place in an overall portfolio to provide spending power in terms of investment opportunities or, well, spending. Bonds can make sense depending on what investors are asking a portfolio to do for them. Matching maturities up with cash flow needs often makes a lot of sense, but dividends from stock holdings can also help fund those needs. In general, though, the farther an investor is from needing to tap the assets we’re managing, the less need there is for bonds.
On the stock side of things, diversification definitely matters. We categorize stock holdings into nine different economic sectors based on their respective lines of business. Each of those sectors will have its respective day in the sun performance-wise, so it’s important to invest across all the sectors if you’re taking a broad-based approach rather than a sector-specific approach. History says each of those sectors will outperform over certain periods, but it’s not always obvious when one of those periods is over the horizon. We’ll adjust sector allocations based on trends we observe or expect to take hold, but we’re making those changes at the margin rather than being “all out” of a sector. A sector might be out of favor, but there are still quality companies in that area.
Diversification at the company level matters, too. You can own too much of a good thing! We want our best investment ideas that fit each client to end up in portfolios, and we want to own enough of each company to move the needle on performance. That being said, we don’t want returns being too driven by a single company’s stock price, because prices depend on investor appetites in addition to financial results. Events might also occur that impact only a single company, in contrast to macro trends like economic growth that tend to impact all companies in some way, shape or form and impact companies in the same business in similar fashions. Diversification among great companies is necessary because unfortunate things can happen to great companies.
On the other end of the spectrum, investors can have too much diversification. Legendary investor Peter Lynch describes “de-worse-ification” as when a portfolio gets fattened with too many holdings so the performance impact of the best ideas gets diluted. We’ve had clients transfer portfolios to us from other advisors and the account will own 200-300 different stocks. A roll of the eyes is entirely appropriate here. We’ll see pages and pages of holdings illustrating $1,000 positions in a $1,000,000 portfolio. Don’t get us wrong, we would gladly pocket $1,000 if it were offered to us, but it’s practically impossible for a holding that size to impact the overall portfolio. If there were higher conviction in the investment, there would/should be a larger allocation. Instead of having 40%-50% of the portfolio in similar small positions, why not allocate those monies into higher conviction investment ideas?!
Successful investing is as much about what you don’t own as what you do own. Don’t own assets if they don’t make sense to own. As for what we do own, let’s make sure it’s diversified across the highest conviction investment ideas. Once we have a portfolio of 30-40 companies diversified across economic sectors, let’s not add companies just to add companies, but if it’s a high conviction idea then by all means let’s add that in, too.