Tag Archives: income

Diversification Myths: Why Are You Investing In Individual Stocks?

By Chris Gilbert The age old question of exactly how many stocks to hold is likely never going to be definitively answered. There are entire books, even courses, on the subject after all. Since portfolio construction is more of an art than a science, in this post I want to break down relevant studies, examine historical data, and analyze some of the best investors in an attempt to come up with the optimal strategy . As always, please share your comments and thoughts below! Talking Points Diversification by the numbers Myths of diversification Why are you investing in individual stocks? “Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett By The Numbers My investing strategy, which is definitely not perfect, consists of holding relatively few stocks (around 10 or so). This is because I want to invest in wonderful companies purchased at attractive prices. I have found that these opportunities, especially of late, don’t seem to come around all that frequently. This also makes me a big believer in holding a decent amount of cash in my portfolio as well. But why adopt this strategy? It’s simple logic, the more stocks you own, or the more diversified you are, the less likely you are to underperform the market. By this same logic, however, you’re also much less likely to outperform the market. Say you own 2 stocks and one doubles while the other stays flat. You still earn a 50% return. With 4 stocks and one doubling – a 25% return. What about more? Say you own 10 stocks and one doubles while the others go nowhere. You’d still earn 10%. 20 stocks… 5%. 100 stocks… 1%. While this may be an oversimplified example, you get the point. The more stocks you own the more your results trend toward average. But let’s look at some more numbers. In the book, Investment Analysis and Portfolio Management , Frank Reilly reviewed studies regarding randomly selected stocks and found that as little as 12 stocks could attain around 90% of the maximum benefits of diversification. He also goes on to note if the individual investor is properly diversified, 18 or more stocks = full diversification according to his research, then the investor will average market performance. According to Mr. Reilly the only way to beat the market is by being less than fully diversified. In his book, You Can be a Stock Market Genius , Joel Greenblatt came to a similar conclusion. Greenblatt found statistics that showed owning only 2 stocks could eliminate 46% of non-market risk. This number climbs to 72% with 4 stocks, 81% with 5 stocks, and 93% with a 16-stock portfolio. As you can see, the amount of non-market risk can be decreased with the more stocks you own. Which was already obvious. But let’s keep going. You would need to own 32 stocks to eliminate 96% of non-market risk and a whopping 500 stocks to almost eradicate it (99%). Greenblatt’s point is, there seems to be a pattern of diminishing returns after a certain number of stocks. Personally, I would argue maximum benefit is to be had between 8-16 stocks. Myths Of Diversification Myth #1 – You can diversify away risk One of the main reasons investors are afraid to concentrate their portfolio is the belief that it’s too risky. While it may be true to a point, can you ever totally remove risk? We’ve already seen you can partially remove non-market risk, also known as unsystematic risk, by holding more stocks. But systematic risk is a different animal. This type of risk cannot be diversified away. Consider all of the factors that affect the stock market such as macroeconomics, irrationality, or interest rates. You’ll never be able to remove these elements from the equation if you own 1,000 stocks. Think of systematic risk as the inherent risk of investing in stocks. Myth $2 – Overdiversification is safer So what, you say. It still seems safer to own 100 stocks compared to 10. But is it? While you may dilute your unsystematic risk, how much do you really know about your portfolio? Would you even know which stocks you own? Maybe you invest in index funds, which is totally fine for some by the way (more on that later), but if you’re an individual investor and you own 40+ stocks, there is now way to know the ins and outs of every one. We’ll call this practical risk. Practical risk means you may lose your main advantage in the stock market, competitive insight. When you overdiversify, you may miss out on a great opportunity and be saddled with a regrettable investment because your focus is stretched too thin. Myth #3 – Diversification can increase success I’ve already explained two reasons why this is a myth. The more stocks you hold, or the more diversified you are, the more your results trend toward average. This inherently decreases success, unless you want average. Secondly, when you own too many stocks, practical risk increases. Overdiversification makes it very difficult to invest in wide-moat, wonderful companies. There simply isn’t that many great opportunities available at any given time. This also decreases chances of success. Lastly, when you begin to invest in many different stocks just to increase diversification, you increase portfolio turnover. This inevitably leads to more fees and commissions, which also puts a damper on potential success. “We believe that almost all really good investment records will involve relatively little diversification. The basic idea that it was hard to find good investments and that you wanted to be in good investments, and therefore, you’d just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, it’s proven to be an obviously good idea. Yet 98% of the investing world doesn’t follow it. That’s been good for us.” – Charlie Munger Why Are You Investing In Individual Stocks? So we’ve seen the more stocks you hold, the less chance you have of underperforming the market. This also means the less chance you have of outperforming the market as well. By this logic, the only way to increase our chances of success is to hold less stocks than a completely diversified portfolio. By doing this, we take on the inherent risk of owning stocks, so the real question to ask yourself is why are you investing in individual stocks? “If you want to have a better performance than the crowd, you must do things differently from the crowd.” – John Templeton If your answer is to invest your money in a proven vehicle that, historically speaking, beats all other investment options… and you don’t want to take the time and effort to perform proper fundamental analysis on each and everyone of your stocks, then I would recommend an index fund . I mean let’s face it, we’re not all Warren Buffett or Peter Lynch and we’re likely not going to be. But there is still no situation I would ever recommend going out and buying 50 some odd stocks just to say you’re diversified. As we just talked about, this can actually increase risk and reduce your chances of success in a variety of ways. Index funds, on the other hand, are a great way to expose yourself to the stock market and are likely to beat every fund manager over the long haul anyway. Now, if you’re answer is you think you can beat the market, then I recommend you keeping a fairly concentrated portfolio of 8-12 stocks. Why 8-12? Well, for one, you don’t want to be too diversified for all the reasons stated above. And secondly, we’ve seen you can only diversify so much before the benefits begin to severely drop off. Lastly, if you’re really practicing a true value investing strategy, it’s unlikely you’re going to find an abundance of opportunities out there. To mitigate risk, search out high-quality companies with a competitive advantage, and purchase when they’re selling at a discount to their intrinsic value. By concentrating your portfolio, you can obtain a thorough understanding of each company, and coupled with a value investing strategy, decrease risk while increasing returns. Summary Strictly reviewing the numbers, it makes little sense to overdiversify your portfolio. Overdiversifying will not eliminate all risk nor increase your chances of success. If you are willing to practice a value investing strategy and research each of your investments, then focus your portfolio to 8-12 stocks. If not, invest in an index fund. Disclosure: None

America’s Retirement Crisis: Financial Advisors’ Daily Digest

SA Dividends, Income & Retirement Editor Robyn Conti here, subbing in for Gil, who’s observing Passover this week. I’ll do my best to fill his very talented and knowledgeable shoes and continue to keep you up to date daily on the latest FA analysis and news here on Seeking Alpha. It’s no secret that America’s retirement system is in crisis. We are well aware that Social Security and Medicare need shoring up, and that workers today aren’t saving enough to create the financially secure and comfortable retirements most of us dream about. SA contributor Kevin Wilson presents a rather gloomy picture of how truly dire the circumstances of our nation’s retirees and near-retirees are in Of Mice And Men: The Retirement Crisis In America . He aptly points out that traditional retirement planning assumptions have broken down over the past few years, and that savers can no longer rely on tried-and-true investment methods like asset allocation because expected returns across all asset classes are bunk due to central banks’ insistence on ZIRP and NIRP policies across the globe. So what does that mean for the best laid plans of retirees and near-retirees? Wilson writes: The crux of the problem then is the low expected returns on all types of investments, as discussed briefly above and mentioned by many other analysts. As a consequence, the average person must either withdraw much less from their investments in retirement than they actually will need (i.e., accept a lower standard of living), or as mentioned above, retire significantly later than planned or save a multiple of what was assumed above. National data suggest that the average investor has been chasing yield in a vain attempt to make up the difference through investment magic. Unfortunately, yield chasing doesn’t end well historically, and there are already signs that it is failing now… Wilson then goes on to cite programs that desperately need reform at the government level, i.e., Social Security and Medicare — which he calls the “bedrock” of retirement planning — and discusses strategies for addressing the problem of low investment returns. It’s an interesting read, and Wilson makes several valid points that, in this author’s humble opinion, hold a lot of water, and are definitely worthy of consideration by our lawmakers and others with the power to affect the changes we all want to see in the retirement world. In defiance of reliance on Social Security and Medicare, self-proclaimed “geezer” George Schneider summons the wisdom of the Oracle of Omaha Warren Buffett in his piece, How Greedy Retirees Steal Candy From Fearful Babies , touting the old adage investors know so well: “be greedy when others are fearful.” Schneider touts interest rate-sensitive stocks, especially REITs, advising that now is the time for the income-oriented and dividend-hungry to jump in while prices are down and investors are fearful, to reap those profits when markets “normalize.” Here are a few more posts from the day that contain items of interest for financial advisors: What are your thoughts? Are recession fears overblown? Comment below.

Generating Income From Unlikely Sources: Financial Advisors’ Daily Digest

SA Dividends, Income & Retirement Editor Robyn Conti here, subbing in for Gil, who’s observing Passover this week. I’ll do my best to fill his very talented and knowledgeable shoes, and continue to keep you up to date daily on the latest FA analysis and news here on Seeking Alpha. Generating income these days is more difficult than ever due to the low rate environment, but that hasn’t stopped masses of investors from jumping with both feet into income investments that are too costly relative to their yields. Joel Johnson from True-Bearing.com emphasizes the importance of helping income-oriented clients invest for specific outcomes, and talks about how those solutions are more likely to be found in more “off the beaten path” investments, which present profit-generating opportunities for advisors: Outcome-oriented investing, once dominated by institutions offering low cost defined benefit plans, is a challenging job… Investment advisors can now create risk-aware portfolios designed to meet the specific income needs of their clients. The portfolios contain funds that invest in non-traditional sources of income. The portfolios should feature investments that are not overly expensive. Investing in themes is integral to generating alpha and hedging your portfolio against macroeconomic changes…” Harry Long’s article on ETF dividend strategies dovetails nicely, proposing several ideas for seeking out alternative income instruments while avoiding volatility. In contrast, on the subject of outflows from income investments, if you or your clients have muni bond funds coming due in the next few months, now’s the time to take action. SA contributor Patrick Luby highlights an historical summer trend in muni bond redemptions , per Bloomberg: … this year is expected to follow the same pattern, with $38.2 billion rolling off in June, $33.5 billion in July, and $29.9 billion in August. (The monthly average this year is just under $26 billion.) Forecast redemptions include maturing bonds as well as bonds that have been advance refunded or current refunded and are expected to be called away. For those fond of quick math, that’s more than $100 billion in redemptions — quite a round, and a rather hefty, number. Luby points out that, while reinvesting principal is generally an attractive benefit of owning individual muni bonds, due to the current rate situation and economic uncertainty, advisors and their clients may be unsure how to, or even if they want to, reinvest. He suggests those who have bonds coming due (maturing or pre-refunded) in the next several months consider the following: Changing asset allocation by using redeemed municipal bond proceeds to invest in another asset class will cause a shift in the overall portfolio risk profile, and should not be done unless called for by the investment plan. Don’t wait for the principal to be returned to you to consider what to do. Due to the volume of principal that will be seeking reinvestment, muni bond investors may find themselves competing with each other for a limited supply of appropriate bonds. Investors in high-tax jurisdictions with a preference for in-state double-exempt bonds may find their options even more severely reduced. Consider making provisions for reinvestment in advance of your bond’s redemption date. Pay attention now to the new issue calendar for appropriate issues that will settle after the maturity date of your maturing/refunded bond. As an alternative to individual bonds, you may wish to consider using a municipal bond ETF to maintain asset class exposure while waiting for a suitable replacement security. (To learn more about doing this, read my recent article about using duration as a guide to selecting municipal bond ETFs, available here .) These are definitely items of importance for advisors and muni bond investors to keep an eye on should redemptions proceed as forecast. Finally, since there appears to be quite a hefty focus on oil, where it’s headed, and the frothy politics involved therein, here are several stories offering a variety of views and insights on the volatile commodity: Daniel Jones takes a particularly bullish view on oil . However, Simply Investing says don’t expect the rally to last for long . The Heisenberg breaks down the nefarious geopolitics of oil price movements . Resident SA commodity expert Andrew Hecht explains how to read the “tea leaves” for crude following the OPEC stalemate in Doha earlier this month.