Best Number of Stocks for Optimum Diversification?

[TwoCitiesCapital]

It's about finding what works for you. As has already been mentioned:

 

1) The consequences of diversification are less than the consequences of concentration in an adverse scenario BUT

2) There is validity to the idea of allocating to your best idea over your 33rd best idea

 

I try to find a balance. What I've found from being in the markets is that my best ideas typically fail to perform while lower conviction ideas have driven most of my positive performance. The individual blow-ups that I've been invested in were some of my best ideas as well.

 

So, I recognized that I don't have the ability to differentiate my #1 idea from my #7 or #8 idea and that oftentimes #8 has outperformed everything. So I tried to eliminate blow-up risk and over-allocation to performance anchors while increasing exposure to other value-add opportunities.

 

This has led to a few changes in my strategy:

 

1) Maximum position limits of 10% measured by total capital risked by current portfolio value

2) More allocation to lower conviction ideas to reduce blow-up risk while increasing likelihood that something in the portfolio performs

3) More likely to trade around the core position of my larger/familiar allocations to try increase the performance over "buy/hold" strategy

4) Dividends are re-invested into the portfolio's smallest positions and new ideas to grow those instead of further entrenching large positions

 

What this has led to large positions in 7-8 single name trades representing 4-8% allocations apiece that I follow very closely and intend to hold long-term, but will trade around.

 

There are also three or four themes/narratives that drive the remaining positioning:

1) Bearish on U.S. equities/assets

2) Bullish on diversified EM equities

3) Bullish on real assets relative to financial

4) Branded retail in the U.S. will survive disruption of distribution/sales models

 

So basically, half the portfolio is in 7-8 high-conviction, long-term names while the remaining half is diversified across baskets of individual names and mutual funds/ETFs to best get exposure to those themes playing out.

[Wild]

 

2) There is validity to the idea of allocating to your best idea over your 33rd best idea

 

 

I still am somewhat torn over this mantra. To me it sounds like you pick the 30 stocks you like best, but your 30th stock is clearly not as good as your #1 stock. But that's not what Diversification is whatsoever. The 30th pick isn't intended to be the "best" pick of the bunch, it's intended to have a different reaction to market conditions than your #1 pick. The idea that your holdings are bought in order of how much you like them is absurd, and isn't at all diversification. You allocate to mitigate risk, not gain return. And from that standpoint the definition of "best" changes. Because the rationale for why you invest in your #1 pick SHOULD be different than why you invest in the others.

 

 

[TwoCitiesCapital]

 

2) There is validity to the idea of allocating to your best idea over your 33rd best idea

 

 

I still am somewhat torn over this mantra. To me it sounds like you pick the 30 stocks you like best, but your 30th stock is clearly not as good as your #1 stock. But that's not what Diversification is whatsoever. The 30th pick isn't intended to be the "best" pick of the bunch, it's intended to have a different reaction to market conditions than your #1 pick. The idea that your holdings are bought in order of how much you like them is absurd, and isn't at all diversification. You allocate to mitigate risk, not gain return. And from that standpoint the definition of "best" changes. Because the rationale for why you invest in your #1 pick SHOULD be different than why you invest in the others.

 

The goal for those people isn't diversification - it's return maximization. The people who think like that proponents of concentration and not "di-worse-ification". If you have the ability to correctly analyze companies, you want all your money in the baskets you have the edge in and none allocated to the companies/industries you don't have a clue about. The goal isn't to eliminate volatility, but rather to take advantage of it.

 

Diversification isn't a means of return maximization. It's intended to be a risk reduction to limit the risk of individual company. Doing so also limits upside volatility when individual companies do well. Diversify enough and you've become the market and are destined for average market returns.

 

People who preach allocate the most to your best ideas are doing the exact opposite of diversification - over exposing themselves to individual company risk because they believe that company will do better than the average.

 

[Wild]

 

2) There is validity to the idea of allocating to your best idea over your 33rd best idea

 

 

I still am somewhat torn over this mantra. To me it sounds like you pick the 30 stocks you like best, but your 30th stock is clearly not as good as your #1 stock. But that's not what Diversification is whatsoever. The 30th pick isn't intended to be the "best" pick of the bunch, it's intended to have a different reaction to market conditions than your #1 pick. The idea that your holdings are bought in order of how much you like them is absurd, and isn't at all diversification. You allocate to mitigate risk, not gain return. And from that standpoint the definition of "best" changes. Because the rationale for why you invest in your #1 pick SHOULD be different than why you invest in the others.

 

The goal for those people isn't diversification - it's return maximization. The people who think like that proponents of concentration and not "di-worse-ification". If you have the ability to correctly analyze companies, you want all your money in the baskets you have the edge in and none allocated to the companies/industries you don't have a clue about. The goal isn't to eliminate volatility, but rather to take advantage of it.

 

Diversification isn't a means of return maximization. It's intended to be a risk reduction to hedge out the risk of any individual company that might go bust (i.e. limit downside volatility). Doing so also limits upside volatility when individual companies do well. Diversify enough and you've become the market and are destined for average market returns.

 

 

I 100% agree. My original response was written under the impression that the mantra was being used as a basis for our conversation on Diversification,. When as you point out in your second sentence, it has nothing to do with Diversification, which is what I was agreeing with.

[clutch]

You guys have touched upon an important point.

 

If you assume a same expected return for every single investment opportunity, there is no reason NOT to diversify. In this case, adding more stocks into your portfolio does not change the overall expected return, but would simply reduce the variance.

 

In reality, you'd typically assume different expected returns for different investments. In that case, you have a multi-objective problem. By concentrating on investments with highest expected returns, you are maximizing the overall expected return but increasing the variance in the overall return. As you add more investments with lower expected returns, you are reducing the overall expected return but decreasing the variance (which BTW in theory is also correlated with the chance of permanent loss of capital).

 

(Actually, in the scenario described in my 2nd paragraph, you could also rank investments with the same expected return, based on the confidence / variance you assume on each investment. You concentrate on investments with highest confidence / lowest variance. But in this case you are minimizing the variance, not maximizing the return.)

 

 

[Guest jeffswaldron]

What's the best number of children I should have for optimum diversification?    :)

[BG2008]

Hey all:

 

My Dad (with my help), has EASILY exceeded market returns for a long, long time now...he has a rather large portfolio, perhaps coming close to 100 different positions.

 

One of the things he has done is just buy & hold for a long time, sometimes for 20+ years.  He will sell a position, but it is relatively rare.  He usually just buys & holds on & on & on.

 

Sometimes it does not end well...but sometimes it ends up rather incredible...10x returns on a stock?  hahahahahaha, try 100x or more returns.  He has a few 100x returns, and several 40X-50X returns.  Of course, this has taken 10, 15, 20 years to achieve.

 

He bought Apple back in 1997.  Steve Jobs had just come back to the company....

 

He has held Seaboard since it was in the very low 100's....

 

He has NewMarket.....Southern Company, Checkpoint Software, National Beverage, and others that were bought 15-20 years ago.

 

The other interesting thing is the dividends he gets.  He has some positions where he gets back his initial investment with every year in dividends....a couple/few positions with every quarterly payment of dividends!  Talk about taking risk off the table!

 

He also has some incredibly obscure//hard to get positions.

 

So for him, a huge, incredibly diversified portfolio seems to work out very, very well.

 

Who's your daddy and what does he do? http://i.imgur.com/XtHQKml.mp4

[randomep]

What's the best number of children I should have for optimum diversification?    :)

 

Depends on what your goals are, if your goal to to spread your genes, then I think you should move to a welfare state like Canada then I have as many as possible with as many women as possible, and leave them all out to dry.

 

you have to remember, there is an optimum number for investment because you have a limited supply of money.  But you have an unlmiited supply of sperm.

[Spekulatius]

Can you truly understand and keep up with the 30 companies you own?

 

Can you truly understand 3 companies you own?

 

I don't even understand the company I am working for, much less the the companies I own. I like to have a good amount of diversification and own 30+ different companies. Somce of these are just stub positions, where I bought a starter with the intend to buy more, if the share prices becomes more attractive and this never happened. I am constantly surprised, which stocks are doing well, compared to what my best idea at that point was. I have basically given up on the whole concept of best idea, I see ideas like a portfolio, you have different train of thoughts that result in actionable buys, but I really don't have any idea, which one is more likely to work out to begin with.

[Patmo]

The best number of stocks for optimum diversification is 10

[sarganaga]

It's about finding what works for you. As has already been mentioned:

 

1) The consequences of diversification are less than the consequences of concentration in an adverse scenario BUT

2) There is validity to the idea of allocating to your best idea over your 33rd best idea

 

I try to find a balance. What I've found from being in the markets is that my best ideas typically fail to perform while lower conviction ideas have driven most of my positive performance. The individual blow-ups that I've been invested in were some of my best ideas as well.

 

So, I recognized that I don't have the ability to differentiate my #1 idea from my #7 or #8 idea and that oftentimes #8 has outperformed everything. So I tried to eliminate blow-up risk and over-allocation to performance anchors while increasing exposure to other value-add opportunities.

 

This has led to a few changes in my strategy:

 

1) Maximum position limits of 10% measured by total capital risked by current portfolio value

2) More allocation to lower conviction ideas to reduce blow-up risk while increasing likelihood that something in the portfolio performs

3) More likely to trade around the core position of my larger/familiar allocations to try increase the performance over "buy/hold" strategy

4) Dividends are re-invested into the portfolio's smallest positions and new ideas to grow those instead of further entrenching large positions

 

What this has led to large positions in 7-8 single name trades representing 4-8% allocations apiece that I follow very closely and intend to hold long-term, but will trade around.

 

There are also three or four themes/narratives that drive the remaining positioning:

1) Bearish on U.S. equities/assets

2) Bullish on diversified EM equities

3) Bullish on real assets relative to financial

4) Branded retail in the U.S. will survive disruption of distribution/sales models

 

So basically, half the portfolio is in 7-8 high-conviction, long-term names while the remaining half is diversified across baskets of individual names and mutual funds/ETFs to best get exposure to those themes playing out.

 

This is an excellent process. The reasons given for allocating to lower conviction ideas are (IMO) very important. Thanks for your insights.

[flesh]

It's been insightful for me to hear from so many experienced investors, it's helped me learn something about myself.

 

Personally, my largest positions nearly always outperform (80-90%) the rest. For posterity, this has only been since 2012.  Over time I've moved from around 15 to 8 positions, often times having 20-35% in one idea. That said, when I have a 35% position it's usually when I'm averaging down hard and I currently or will soon have long term gains on the initial position of around 20%. After the price recovers I'll sell down to around 20% or so. To this day all my losers have been 5% or less positions and I've never had a loser that was 10% or greater.

 

This evidently binary discussion about whether you really know a business seems a bit silly. Knowing anything isn't binary, in most cases, it's a matter of degree. Knowing that's not especially insightful, I thought I'd point it out because no one else has, which is strange. It's about knowing more about some businesses and having tangible reasons to believe that you have it right and that your downside is capped. I can certainly understand bright folks not having the time to do deep research and gain a level of understanding that naturally causes confidence to build over time. However, to my way of thinking, it astounds me that bright folks with the time, brains, and wherewithal can't differentiate between what is or isn't a better position.

 

There's so many useful heuristics we've all been exposed too enabling us to sort these things out. Top of mind, upside/downside, competitive advantages, balance sheet strength, diversification within the entity itself, acyclical or counter cyclical tendencies, management's who are shrewd capital allocators, multiples so low that you have your money back in single digit years, on and on. I can't comprehend how one could apply these few filters and not see clearly that some companies are better than others. 

 

Half of what goes on between my ears day to day when I'm not busy is simply trying to kill all my companies, this never ends. If I can't kill them, they are cheap,  and the broader thesis looks good, plus I can't find ten different companies that are quite so good, why not dig in there, give yourself a chance to succeed at a high level?

 

Anyways, all of this said, I don't want to sound self important, reality is, although all my large positions do well I have a very difficult time holding on to them. I generally miss out on a large part of the gain , often I miss the main course, as a result of a number of personal weaknesses. Ig, my returns are good not great, yet. I suppose it's hard to become someone who get's all the different aspects correct over time. Sometimes, I just wish someone would lock me out of my accounts. Anyways, I am improving on this at least. Recently I noticed I was getting neurotic about such low volatility and so I went camping for a week with no reception, it's a start.

[DooDiligence]

Is there any validity to diversifying with corollaries?

 

Healthcare & Vice (a heart valve manufacturer & a cigarette co) (a confectioner & an insulin producer)

Energy Sector & Trucking Companies (take your pick)

Banks & Everything Else

[oddballstocks]

Some excellent responses.  As a few have pointed out there are two discussions happening:

 

1) Return maximization

2) Risk reduction

 

I personally believe that by reducing risk you increase returns.  But that only makes sense when the market crashes.  Since we've reached a permanently high plateau concentrating in a few ideas since 2009 has worked best. 

 

I remember reading an investor's strategy back in 2007 where he invested in low beta dividend paying stocks.  The idea borne out of research was low beta stocks didn't decline as much as the market.  He accepted an 8% return over a 12% return with lower volatility with the idea that his 8% would outperform during a crash.  Thinking about this now he hit it out of the ballpark because with low rates those dividend stocks crushed it.

 

It will be interesting to see how this board changes when we finally (if ever!) get a crash.  A lot of investing recently seems to have drifted into moonshots.  But maybe I'm just not learned on the new value moonshot way of doing things yet.

[Voodooking]

Firstly, I'd like to thank everyone who replied to my OP.

 

I've been thinking about all the responses and been doing a lot more digging online and in some books and sifting through quotes from various investors I admire.

 

My conclusion from all this is that I'd be happiest with 20 stocks in my portfolio, allocated equally between my positions (i.e. 5% in each).

 

This gives me enough scope to make a decent return, while avoiding the risk that any one position can blow up my portfolio.

 

At the moment I have all my money in my best 4 or 5 ideas, but I will add to this, taking a new position when I find one and when I have additional cash to deploy; buying one at a time until I have 20 positions, then selling one every time I want to add a new position.