We’re often told to diversify a lot with our stock positions. While some diversification can make sense, if we’re picking our stocks ourselves, how much of this do we need?
Phil Fisher is considered by some to be among the greatest investors of all time. Warren Buffet, who is widely regarded to be in this category, counts Fisher as a mentor. Fisher wrote an influential book about investing called Common Stocks and Uncommon Profits all the way back in 1958, and while we may question some of his investing philosophy, some of the points he made in this book so long ago still make sense today.
Fisher told us back then that “investors have been sold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much into companies they know nothing about.”
Fisher obviously focuses on fundamental analysis, and speaks of investing as only involving this sort of analysis, whereas in today’s world technical analysis plays a much bigger role. Charts were around back then but almost all investors believed that the keys to the kingdom were to be found by poring over financial reports.
The real idea behind this strategy is to look to hold stocks for such a long period as to have market risk even out more and therefore reduce its effect, even though you never can get rid of this. This means that we’re going to ride the waves up and down of the market and hopefully, after enough time, the ocean itself will rise enough.
The movement of the market itself plays a fundamental role in shorter-term analysis, and business results aren’t well correlated at all to this time frame, but they are at least better correlated with the very long term, like buy and never sell, which was the preference of Fisher.
We would now have to preface these remarks with something like if you are investing in stocks based upon focusing on their long-term business outlook, then diversifying into companies that you have not researched thoroughly enough, then you aren’t applying your investment strategy properly. It would be very hard to disagree with this.
Not Over-Diversifying is Plenty Important
His mentioning of our not wanting to over-diversify may have more universal merit though, and this is something that investors should at least be willing to question. Investors really don’t pick their own stocks to the extent they did in 1958, but they certainly still diversify a lot, and we want to make sure that the amount of this that we include isn’t excessive and can be justified.
Aside from the small percentage of investors who pick all of their own stocks, most go with either actively managed funds or index funds. They may to seek to diversify their funds though, and are often encouraged to do that, so that means a whole lot of diversification indeed.
The main reason why we go with index funds so much isn’t because of diversification, but is rather due to the benefits of simplicity that this strategy provides. People don’t have to pick stocks or make any decisions about the content of their stock portfolios when they just invest in an index, nor does anyone. You don’t have to know anything about the companies or anything else to do this.
If we are investing in actively managed funds, or having someone pick our stocks for us, it’s not on us at all to decide any of this, although we might want to examine just how much diversification is being used to decide whether this is an appropriate amount. If we are choosing ourselves though, we will need to understand the role of diversification lest we include too few or too many stocks.
For whatever reason, the investment industry as a whole place a lot of weight on risks to individual companies and sectors, and virtually ignores market risk. Market risk is the big elephant in the room though and this always needs to be in the forefront of our minds as we seek to manage risk.
Putting our eggs in more baskets therefore won’t help very much if the big basket, the stock market, starts to topple over. When we are deciding between less volatile stocks to hedge our losses or not, this becomes a decision between losing a lot of money or even more money, and neither are good choices.
Managing market risk can only be accomplished one way, and that’s by timing our positions according to the state of the market. This is deemed to be taboo by a lot of people, and Phil Fisher would place near the head of this line.
We can diversify between markets though, and a lot of people do this by putting some of their money in other assets such as bonds, or held back in cash, but they do not tend to do this in a way that is responsive to changing conditions, and just use this to limit both their gains and losses. They limit their gains more than their losses though in any market that has moved forward at all, which is a requirement for long-only investors.
Being on Duty Reduces the Need for Diversification
Assuming that we do have a workable strategy to distinguish between stocks, the more of them we add to our portfolio, the less performance we may expect. There is a cost-benefit relationship to this, with the benefit being more diversification and the cost being lower expected returns.
If we had the time and had at least a decent potential to learn how to pick stocks for investment purposes, we could go over all the stocks in an index and go with the best ones, and at the same time look to provide at least a satisfactory amount of diversity. How much will be satisfactory will depend mostly on what our response will be if things do go awry.
There is a huge push for just staying the course, which has been taught to us by an investment industry that prefers we do just that. Our making decisions may reduce our risk, if the decisions are good ones that is, but this always increases the risk to those who manage our investments as far as losing them goes.
There are many traders, on the other hand, who just trade one thing, and they aren’t at all concerned about diversification because they will be out of the trade long before things turn all that sour. Diversification is therefore used as a crutch a lot for the refusal to act, much like someone might be prepared to put their hands over their face if they are worried about getting punched. This may reduce the impact of this, but we also need to remember that we can just run away when we see the fists start to come at us.
We may still want to take more than one position at a time, to at least add in some diversity, and if we’re planning on holding our positions for a number of years we should take sector risk into account somewhat, because we will need to give our positions enough room to breathe and not just step aside at the first real punch like a trader would. This would require us to be in and out of positions a lot more, and we usually will want to limit this by setting our exit thresholds higher.
Stock picking has become such a niche nowadays though, as people would much prefer to strictly limit their participation in their own investments. If they don’t know much about stock picking and aren’t really that motivated to learn how, this can be a very wise decision.
If we are up for this though, how many we pick will depend a lot on the differences in outlooks between them. If several stocks look similarly good, it can make sense to add more, but since this adds a little at least to our trading costs, we don’t want to overdo this either.
Usually the relative outlook isn’t so close though, and there are a lot of companies in an index that we may want to reject out of hand. Anything that does not look so positive should be automatically excluded, to be perhaps considered when things look better.
For the most part though, our list should be rather short, for a lot of reasons, including the impact that this would have if we are actually going to manage these positions actively. If we are not, well we’re not really on a sensible course anyway, and even can be seen as acting in a contradictory manner, wanting to manage risk by only focusing on certain risks but not that interested in managing the biggest ones.
Some may point to how much fund managers struggle at this and just throw up their hands and go with an index fund, but doing this will billions of dollars is a completely different and so much more challenging of a game than it is with our much smaller portfolios.
It’s fair to say though that both index funds and managed funds rely far too much on diversity than would be ideal on a cost-benefit basis, with the actual good picks becoming diluted too much by the dogs in the fund, ones that are added to simply add to the population of the kennel.
Fund managers are required to do more of this since they are stuck in their positions more than it would be ideal to be, but we are not, but only if we understand this.
For those who do choose to manage things, less can very often be more when it comes to the number of stocks we own. If we can put together a nice short list and pay the attention to these positions that they deserve, we can indeed lead to a more optimal style of investing.
If we are worried about a stock going down too much, we could indeed add more stocks so that we don’t lose so much if this happens, but we could also choose to just sell if when it starts looking poorly. The idea of just selling instead is simply just not on the table for a lot of investors, but exiting needs to at least be allowed to speak.