Diversification is often touted as the be-all end-all. Many advisors suggest holding dozens or even hundreds of different stocks in your portfolio. They say that you should hold several different mutual funds since that is the only way you can achieve enough diversification if you don’t have several million dollars in the bank.
This is thinking like a speculator, however, and not like a business owner. Speculators think it is all about chance and that you cannot predict what any particular stock will do. You therefore spread out your bets to cover all of the bases and let the natural tendency of the market to grow lift your boat.
Business owners, on the other hand, usually put all of their money into one business – their own. They even go out and borrow money from family, friends, venture capitalists, and even credit cards. They have a clear vision of where they want to take the business and how it can make money. All of their energy is focused on the one endeavor. Of course, businesses can and often do fail, and when they do it can be financially devastating to the business owner.
Stock investors also lack one critical advantage the business owner has, control. As an investor you cannot control what the board of the company does or what the company officers do. Putting it all on the line when you don’t have control is even more risky than doing so when you do have control. The right balance lies somewhere between full diversification and betting it all on one horse.
When I look at diversification, I base it on a simple principle – how much am I willing to lose. If I put $5000 in a single stock, there is a very real chance that the company may go bankrupt and my $5000 will be gone forever. I’ve found that perhaps 1 in 20 or 30 stocks will do this, so it is not that likely but it is extremely possible. It is also possible that the stock may drop in price somewhat, or just keep trading within a range while the rest of the market is going up. You then miss out on a significant return hat you could have had if you had just been in index funds.
While staying below the maximum I’d be willing to lose in any one position, I try to concentrate in a few positions when I don’t have much to invest and therefore don’t have that much to lose. If I make a great pick and buy just 100 shares of a company’s stock and it goes up 10 points, I’ll only make $1000. Even if it goes up 20 points, I’ll only make $2000. This is better than a loss, but won’t be life changing. I like therefore to buy 500 or 1000 shares. If I buy 1000 shares and it goes up 10 points, I’ve made $10,000. If it really takes off and goes up 100 points over the period of five to ten years, I’ve made $100,000 – enough to buy a small house in many parts of the country. This is the power of concentration.
Of course, these can be fairly large positions. If the stock costs $15 per share, 1000 shares would be $15,000. If the stock went to $50, that would now be $50,000 worth of stock. I therefore wouldn’t start right off of the bat putting $15,000 into one stock if all I had was $15,000. I also wouldn’t hold $50,000 worth of stock in one company if all I had was $50,000.
Instead I would start out by picking three to five stocks that I liked as long-term purchases. These would be the best stocks in five different industries, and each of these industries would be hot industries that have plenty of room for growth. I then would pick up 100-200 shares in one of the companies. I’d save up more, and buy 100-200 shares in a different company. I’d do this for the third company, and then the fourth, and then the fifth. I’d now have a portfolio worth maybe $20,000 with positions of about $3000-4000 in five companies. I would then start building up these positions, buying 100-200 shares at a time of whichever company seemed to be the best value at the time.
This would continue until I had 500-1000 shares in each position. At this point I would have several positions each worth about $15,000-$20,000. If one failed entirely, I’d lose $15,00-$20,000, but it would only be about a 20% loss for the portfolio overall. There would be times when two or more positions fell in price at teh same time, but the chances of more than one company declaring bankruptcy and the entire position being wiped out is fairly low.
At this point I would start to think about more diversification. As the positions grew I would take some profits and as I saved up more money I would start to put some of my money into index funds and ETFs. This would be money I was content to grow at the rate of the return of the markets in general. I might do this until I had about 1/2 of the portfolio diversified and the other half concentrated. Starting out this way — buying shares of one stock and then shares of a mutual fund, is another possibility. This would reduce the levels of the fluctuations in the value of your portfolio when it was small.
As I started to have $100,000-$250,000 in the diversified funds, I could start letting some of the positions get a bit larger, maybe as large as $30,000-$50,000, because a whole loss of a position would be a small part of my portfolio overall. I’d get less risky over time, using a smaller and smaller portion of my portfolio for the concentrated positions, but the size of the portfolio would be growing over time, so the absolute size of the positions might actually remain about the same. For example, if I had a $10 M portfolio, I might have $8 M in diversified index funds and then have twenty large stock positions worth around $100,000 each for the remaining two million dollars. The diversified portion might also contain some fixed income investments to provide income and further reduce volatility risk.
In summary, I tend to use concentration in a few great companies to improve returns, but keep positions manageable relative to the size of the portfolio. At the start I would concentrate more, having less money to risk and therefore smaller potential losses when compared to income from work. As funds built up, I would shift to a more diversified approach to reduce risk and preserve the capital I’ve built up.
Note that this strategy takes a strong stomach. Large losses can and will happen from them to time and one needs to be willing to stick it out and wait for things to improve. If this does not allow you to sleep at night, there is nothing wrong with accepting the market returns and buying a diversified set of mutual funds. You’ll do better than 90% of the fund managers out there in index funds and do a lot better than those in bank CDs or credit cards.
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.