Rethinking Diversification

I’m a big fan of diversification, taken to the highest extreme I can garner and at the lowest price I can find. Accordingly, a big chunk of my portfolio consists of fairly dull exchange traded funds that track the Vanguard Total Stock Market Index (VTI), or the Lehman Aggregate Bond Index (AGG). The basis for my strategy is that the markets are better at pricing companies than I am, and the law of averages will more or less guarantee that my returns will be no better than the market average over long stretches of time – and possibly quite worse. Also, the truth is that I’m lazy. I don’t want to spend too much time researching individual companies or getting on top of what’s going on with them. My highly diversified (and very passive) investment approach has rendered my stake in any given firm minimal to the point where I can afford not to care.

I’ve come to realize that guys like me are the main problem with the stock market, precisely because there are way, way too many of us placing the exact same trade. Whenever a trade gets too crowded, stuff tends to blow up. Almost every time, in fact, this time is no different.

And there’s a more structural reason why passive, diversified investment styles have failed: well diversified shareholders think they don’t have to care if any particular company runs amok. Hey, the CEO gets a big bonus after the company’s stock price has crashed 70%? Not my problem! Company takes Federal bail out money and spends it all by sending managers out to get $100,000 manicures in Florida? Hey, let the New York State Attorney General sort that out! When it comes to shareholder activism, diversification leads to the ultimate prisoner’s dilemma. It sure seems that the top ranks of management have figured that out, too. No wonder the system is crashing!

Here’s the solution I’ve built into my investment strategy. Yes, I keep a core of diversified exchange traded funds, but I do something else on the periphery of my portfolio. It’s not investing. It’s owning. And there’s a big difference.

First, I pick a few companies that I like. Generally, I like companies that are worth more to me than what the market is willing to pay for them, so you’ll see a few companies with high book values relative to share price, low price earnings ratios, sitting in my portfolio. But what I’m mostly looking for are companies with great management, and where good ideas get up the management chain rapidly.

Second, at any time I think I have some useful information or ideas for my companies, or if I think management is screwing up, I don’t dump the stock right off the bat. Let’s suppose I have a problem with the CEOs bonus this year. I will skim the most recent SEC filings and find the direct phone number for the CEO, and will put a call into his or her assistant. More often than not, a personal assistant to a CEO is as smart as can be, probably at least as educated as I am, and someone who knows how the boss thinks. After speaking with the assistant, I’ll write him or her a brief e-mail that contains whatever information I am interested in conveying to the CEO. I keep it short and persuasive. In my experience, this e-mail will get printed out and put on the CEO’s desk where it will be read or skimmed, and either acted upon or rejected.

It’s not my job to manage my companies – with the ones I own, I’m pretty sure that I’ve hired exquisite talent to do that for me, and do it better than I could do. The folks who run the companies I own are busy people, and I don’t want to take up their time - I want them to focus on running the company’s business. But if there’s something wrong happening, or if I think I can add useful perspective, I get involved.

But make no mistake about it. I am no Carl Icahn. I’m a pee wee. But the quality of an idea is not always proportional to the importance of the person voicing it. Good managers know it.

The problem with my approach is that it is irrational from an investment standpoint because it’s quicker to hit the “sell” button than to draft a carefully thought out letter to a company decision-maker who may not even read it, let alone agree to act on it. And nobody’s going to pay me greenmail, either. But when it comes to individual stocks that I own, I don’t think like an investor. I think like an owner. There’s a big difference, and that’s behaving as if I have a stake.

Disclosure: the author owns shares of VTI and AGG

Comments

[iknoknot:]

you've just described the only solution to 'proper' end-to-end investing: become involved and demand accountability.

while you've recently chosen to 'take the field', i fear most investors will continue to enjoy their beers and hot-dogs up in the stands.

apparently the cost of investing correctly transcends the brokerage fees.

thanks for the thoughts,

--ikk

2008 Dec 14 04:09 PM

[bearfund:]

Owning great companies is a fine strategy, but it doesn't really help as far as diversification is concerned. The problem with your portfolio is that it's not diversified at all if everything in it is denominated in dollars and pays out income in dollars. With such a portfolio you are at the mercy of the volatile market for paper money. Right now, if you own stocks, or bonds from dubious issuers, you are taking it on the chin in a dollar short-squeeze. Later you will take another beating as hyperinflation cooks off your bonds and leaves your stocks mired in a growthless cost squeeze. I hope they pay dividends monthly.

A diversified portfolio contains many assets that have nothing to do with the dollar, or act as hedges against its movements. Too many advisors recommend 5-10% in "commodities" or real estate or other hard assets, which is not nearly enough unless you also have a very large and very poweful dollar hedge in your portfolio (like 5x leveraged gold futures).

Better would be 10% mixed agricultural futures, 10% real estate, 10% oil and gas futures, 10% international hard asset producer stocks (miners, agriculturals), 30% gold and silver, 35% dividend-paying stocks with varied global market, industry, and currency exposure but biased toward the best balance sheets and management, 15% global bonds in mixed currencies, and a 20% short position in government bonds, especially Treasuries. Such a portfolio is far better diversified than any dollar-denominated ETF, especially one centered on a particular country or region. It's not nearly as good as a dynamic portfolio that takes advantage of opportunities to short or avoid bubbles and capture arbitrage spreads, but as a hold-and-forget mix it's hard to do better. If you owned this for only the last 6 months you are probably ready to commit suicide. If you owned it for only the 6 months before that, you were probably feeling like a genius. But if you owned it for the last 20 or 50 years you are probably feeling just fine, and have obtained a decent return when measured in terms of the goods and services you need to buy. And that's the point.

2008 Dec 14 04:10 PM

[Robert Nabloid:]

I personally hate diversification. It ties me to market average - and if I'm just going to do average, why get involved or worry about anything at all? It's out of my hand if that's the road I take. Why bother reading or writing anything on SA if I'm tied to average? I'd just be waisting my time and it would be better spent working overtime or with family/friends.

I'd rather do research and use knowledge and education to try and pick companies and industries I know (think) will do better than average. You will never achieve success if you strive to be average.

For some people the stock market is nothing more than a retirement fund they hope maintains value or goes up a little and for them the average diversification strategy is just fine and it is probably the best strategy for them!

Show me someone that got wealthy off the stock market by being ultra diversified? As they achieve success, then most starting moving their wealth around and diversifying it to keep it safer. The closer I get to retirement the more diversified my portfolio will become. To me, diversification is a wealth protection strategy, not a wealth building strategy. So it really depends on what you are trying to accomplish. .

2008 Dec 14 06:18 PM

[Jake2:]

"Such a portfolio is far better diversified than any dollar-denominated ETF, especially one centered on a particular country or region."
Am I stupid or do the components of this portfolio add up to more than 100% Man, that's one spicy meatball!

2008 Dec 15 02:57 PM

[Alex Trias:]

Great point - I should have added a fuller picture of my model portfolio which, in full disclosure, contains plenty of stuff besides US stocks and bonds. As far as commodities exposure, I tend to favor a cash-flow associated, rather than supply/ demand driven, approach. So, for instance, I own oil and gas master limited partnerships, and stock in mining companies, as opposed to (for instance, commodity linked ETNs). In addition, for currency exposure, I'm spending more time in non-dollar denominated equities, although I'm exploring some absolute return strategies. Again, based on what I find of interest, I hope to write an article about how currencies should fit into a diversified portfolio as well.

Thanks for your comment.




On Dec 14 04:10 PM bearfund wrote:

> Owning great companies is a fine strategy, but it doesn't really
> help as far as diversification is concerned. The problem with your
> portfolio is that it's not diversified at all if everything in it
> is denominated in dollars and pays out income in dollars. With such
> a portfolio you are at the mercy of the volatile market for paper
> money. Right now, if you own stocks, or bonds from dubious issuers,
> you are taking it on the chin in a dollar short-squeeze. Later you
> will take another beating as hyperinflation cooks off your bonds
> and leaves your stocks mired in a growthless cost squeeze. I hope
> they pay dividends monthly.
>
> A diversified portfolio contains many assets that have nothing to
> do with the dollar, or act as hedges against its movements. Too many
> advisors recommend 5-10% in "commodities"... or real estate or other
> hard assets, which is not nearly enough unless you also have a very
> large and very poweful dollar hedge in your portfolio (like 5x leveraged
> gold futures).
>
> Better would be 10% mixed agricultural futures, 10% real estate,
> 10% oil and gas futures, 10% international hard asset producer stocks
> (miners, agriculturals), 30% gold and silver, 35% dividend-paying
> stocks with varied global market, industry, and currency exposure
> but biased toward the best balance sheets and management, 15% global
> bonds in mixed currencies, and a 20% short position in government
> bonds, especially Treasuries. Such a portfolio is far better diversified
> than any dollar-denominated ETF, especially one centered on a particular
> country or region. It's not nearly as good as a dynamic portfolio
> that takes advantage of opportunities to short or avoid bubbles and
> capture arbitrage spreads, but as a hold-and-forget mix it's hard
> to do better. If you owned this for only the last 6 months you are
> probably ready to commit suicide. If you owned it for only the 6
> months before that, you were probably feeling like a genius. But
> if you owned it for the last 20 or 50 years you are probably feeling
> just fine, and have obtained a decent return when measured in terms
> of the goods and services you need to buy. And that's the point.

2008 Dec 15 04:10 PM

[Alex Trias:]

Well, as they say, diversification is a terrible way to get wealthy, but a wonderful way to stay wealthy.


On Dec 14 06:18 PM Robert Nabloid wrote:

> I personally hate diversification. It ties me to market average -
> and if I'm just going to do average, why get involved or worry about
> anything at all? It's out of my hand if that's the road I take. Why
> bother reading or writing anything on SA if I'm tied to average?
> I'd just be waisting my time and it would be better spent working
> overtime or with family/friends.
>
> I'd rather do research and use knowledge and education to try and
> pick companies and industries I know (think) will do better than
> average. You will never achieve success if you strive to be average.
>
>
> For some people the stock market is nothing more than a retirement
> fund they hope maintains value or goes up a little and for them the
> average diversification strategy is just fine and it is probably
> the best strategy for them!
>
> Show me someone that got wealthy off the stock market by being ultra
> diversified? As they achieve success, then most starting moving their
> wealth around and diversifying it to keep it safer. The closer I
> get to retirement the more diversified my portfolio will become.
> To me, diversification is a wealth protection strategy, not a wealth
> building strategy. So it really depends on what you are trying to
> accomplish. .

2008 Dec 15 04:12 PM

[bearfund:]

On Dec 15 02:57 PM Jake2 wrote:

> Am I stupid or do the components of this portfolio add up to more
> than 100% Man, that's one spicy meatball!

Maybe neither. It's a 120/20 portfolio; you're short Treasuries. It adds to 100% and you have plenty of room to accommodate volatility.

2008 Dec 16 04:18 AM