Is diversifying necessary?
If you knew the one stock that will have the best returns over your desired horizon, why would you buy anything else? Thing is, that’s a very unlikely scenario.
First, you must be absolutely sure of what you’re doing. And more important than that, you must be correct. What if you pick wrong? In hindsight we all have ten out of ten visions. Journalist love to justify -ex post- why something has happened. Sometimes is as easy as looking for any plausible reasons. The real challenge is predicting it before it happens. Seeing it before anyone else.
As Warren Buffett claims, you must invest in what you know, for risk comes in not knowing what you do. Say you buy a stock, and you don’t know what variables drive its stock price. For example, is it strongly tied to interest rates variation? Or to a commodity price evolution? Is it facing pressure on its profit margins from market forces? How will the newly proposed regulation will affect it, will it be as bad as they claim, or are they overreacting?.
Second, even if you’re truly sure of picking the most undervalued stock out there, there’s the risk of uncertainty. Things that may or may not come to pass, can have an impact on your returns. A war breaking out, a pandemic, a rise in interest rates that wasn’t expected so soon, you name it. That’s why Benjamin Graham, the ideological father of Value Investing -yes, the same sound theory that Warren Buffett adheres to-, used to teach that the future is something you must be wary of. Don’t be overly optimistic about it. Sure, the context is just about to change in favor of your favorite stock, right? What if it doesn’t?.
That’s why passive investors diversify and why it’s vox populi that you must do it. And that’s also why active investors must search deeply for possible undervaluation.
Undervaluation as a safety net
In Value Investing, the margin of safety is defined as the difference between the true worth of a stock (value, what you get) and the current stock price (price, what you pay for). Value is estimated as a theoretical valuation range according to the true earnings power of the stock, say, its genuine funds generation capabilities, while price being the current quotation.
Undervaluation is your margin of safety, in case the context takes a turn for the worse. The margin of safety works both ways: not only it’s your expected upside (what you may earn when the stock comes to the correct and true pricing), but it’s also a buffer in case the context turns sour (which is just a matter of probability). If you invest for a sufficient long time, be sure that you’ll face at least a recession. But on the other hand, if you don’t invest for a sufficient long time, you may be left out of the earnings party.
Who diversifies? Who doesn’t?
Active investors look to outsmart the market by choosing better than run-of-the-mill investors, to get better returns on the long run, which may have a substantial say on your overall wealth. Many of them risk by concentrating on few stocks that they truly believe are undervalued. That’s for example the approach used by Charlie Munger, long life partner of Warren Buffett. Of course, he’s well versed in what he’s doing, and has been profiting a lot out of it.
If you aren’t as sophisticated as him, don’t have the time, resources, or knowledge, or have other things in mind than to focus on stock research, then passive investment will be better for you. Instead of diversifying over several chosen stocks, you just buy the market. That is, you buy an index fund that clones all the shares that comprise an index in their same participations. You’ll neither beat nor be beaten by the market. You’ll be the market. Like a boxer that hangs on to his rival, you may not punch, but will not be punched either. This second approach is what Warren Buffett recommends for people that want to invest for the long run, but don’t meet all the requirements needed for being active.
In this latter case, you might want to be sure to pick an index fund that not only fulfils all legal requirements, but also one that minimizes fees. Your brute returns will be exactly average, so to maximize your net returns, you must minimize fees.
What if you try being an active investor and fail at it? You risk earning less than the overall market in the long run, or even losing money.
How many stocks should you own?
How many stocks should you own if you want to diversify? It depends, it isn’t just a matter of quantity, but also on how different they’re from each other. You may own twenty stocks, but if all of them are USA banks then you aren’t truly diversified. To be correctly and wholly diversified, you should own many different stocks: of different industries, sizes, from different countries, currencies, different legal regulations, etc. This kind of diversification is easier to get by owning several index funds, than by buying the stocks individually.
Another point must be made. When it comes to diversification, stocks aren’t the only financial instrument. You might also want to own corporate and government bonds, or commodities also. For an interest take on that, you may read “Stocks for the Long Run”, by Jeremy Siegel. Spoiler alert: a diversified all stocks holding will usually beat a mixed or full bonds or commodities investment, statistically speaking, when you consider long enough periods.
And there’s much more than that, like derivatives and cryptocurrencies. But please, be sure to know what you’re doing if you’re buying the two latter too. You might be actually increasing risk by diversifying into them.
On the other hand, Andrew Carnegie advocated that, instead of spreading your eggs on different baskets, “put all your eggs on one basket, and then watch that basket”.
On the same line, John Maynard Keynes, the famous economist, said that he could only trust in a few companies, so he concentrated his holdings on those. By spreading among too many stocks, he would have had to buy lesser quality ones, lesser undervalued ones. By spreading on too many stocks, you may not have enough time to deeply research each of them, and be able to follow their development through time.
If you truly follow Warren’s advice (invest in what you know), then there’s possible a very specific set of stocks that you might truly know. Yours might be technological companies, or you might be an expert in real estate, or in commodities, but it’s extremely unlikely that you’re an expert in everything.
As of mid-2022, if you take look at Buffett’s holdings, you’ll see that he owns many stocks, may be more than 40. But if you take a closer look, the lion’s share of his holdings is concentrated in four or five tops. At the time of this writing, in order they were AAPL, BAC, AXP, KO and KHC, with the first one totaling more invested dollars than the other four combined.
Key takeaways (TL;DR)
To be an active investor that concentrates his holdings, like Warren Buffet, Charlie Munger or John Keynes, you:
- Must be very knowledgeable about financial research.
- Must do your homework, as in read and analyze everything necessary to be sure of what you’re doing. It’s a time-consuming activity, and you’ll sweat for it.
- Probably want to concentrate on the stocks you know, the ones you find the most undervalued and are under your reach of specialty.
- Risk getting lower returns than the overall market, even losing money, to get a chance at beating the market.
- Must remember “risk comes in not knowing what you do”.
Otherwise, you’re probably better with passive investment. You won’t be able to brag about it to your friends, but you’ll enjoy an easier ride. Your index fund will already be diversified among several companies, but if you want more diversification than that, you may also buy different market indexes, or even spread internationally in global markets. You won’t beat the market, nor loose to it. You’ll be the market. Finally, if that’s your path, be sure to choose among funds with minimum fees.