How Much Is Too Much Of A Good Thing?

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Includes: AAPL, BT, F, FBR, FE, IMO, JLL, KR, NYCB, SSW, TEVA, VTMGX, VTSAX
by: Bottom Fisher Ideas

Summary

Diversification is widely praised for its risk reduction.

Concentration is celebrated as a means of accumulating wealth.

Diversification and concentration can coexist in the same portfolio.

Investment Thesis

Diversification and concentration seem to be diametrically opposed, and yet they can both be useful tools in portfolio construction. By investing in both diversified funds and a small number of single stocks, you can capture the returns of the market with one hand and attempt to beat it with the other.

Introduction

Something I frequently struggle with in investing is balancing my desire to focus on my very best ideas with my desire to reduce risk through diversification. This has been especially on my mind this past week as one of my holdings lost 30% of its value. How much of a single stock is too much?

Diversification vs. Concentration

Are the concepts of concentration and diversification completely at odds with each other or can they coexist? As investors, we receive conflicting messages about this every day.

Many professionals and pundits promote diversification at every opportunity. Perhaps the biggest champion of this is Jack Bogle and his Vanguard funds. He pioneered the low cost index funds and they continue to gain momentum each year, attracting dollars from active strategies. He preaches simplicity, low fees, and diversification. In his own words:

Don't look for the needle in the haystack. Just buy the haystack!

Or somewhat less ambiguously:

But it is the long-term merits of the index fund - broad diversification, weightings paralleling those of the stocks that comprise the market, minimal portfolio turnover, and low cost - that commend it to wise investors.

This advice is supported by many academic studies that demonstrate that passive investing outperforms active investing in aggregate.

And yet investors and the media revere people who do exactly the opposite. The prime examples of this are Warren Buffett and Charlie Munger. While Warren Buffett often gives lip service to index funds, he is in his heart a concentrated investor, and Charlie Munger even more so.

Warren Buffett famously said:

If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake. Very few people have gotten rich on their seventh best idea.

Charlie Munger is even more extreme in that he prefers to concentrate his investments in his best three ideas. And they both believe that if they have a deep enough knowledge of the businesses that they invest in that they have less risk than with a diversified portfolio.

In the words of Charlie Munger:

The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results.

So which view is right? Or can they both be?

A Balanced Approach

I'm not wise enough to be able to say who is right or wrong, so I attempt to find a middle path. In an earlier article, I discuss how I use a core and satellite approach to my investing. The core is composed of index funds, and the satellites are the active strategies, including individual stocks, individual bonds, and a small allotment to active mutual funds. Essentially, I keep only 50% of my investments in individual stocks, and the remaining 50% is devoted to the broader market: bonds, index funds, and active funds.

The half of my portfolio that is dedicated to individual stocks is divided between 10-15 stocks. While I would love to focus on just 3 stocks like Charlie Munger or 6 stocks like Warren Buffett, I try to achieve a diversification of sector, size, and region with my individual stock picks. Some people have strong macro opinions about sector or country outperformance, but I'm not one of them. So I try to give a strong weighting to my best ideas while not overloading on one or two beaten down sectors or countries.

This sample portfolio of 2 funds and 11 stocks is very close to what I hold in my portfolio, but in a slightly simplified form (the real version is messier and has a few extra holdings):

US Index Fund Vanguard Total Stock Market (MUTF:VTSAX) 30%
Intl Index Fund Vanguard Developed Markets (MUTF:VTMGX) 20%
Technology Apple Inc (NASDAQ:AAPL) 10%
Cyclicals Ford Motor Company (NYSE:F) 5%
Non-cyclicals Kroger Co (NYSE:KR) 5%
Financials New York Community Bancorp (NYSE:NYCB) 5%
Health Care Teva Pharmaceutical Industries (NYSE:TEVA) 5%
Energy Imperial Oil (NYSEMKT:IMO) 5%
Industrials Seaspan Corporation (NYSE:SSW) 5%
Materials Fibria Celulose (NYSE:FBR) 3%
Utilities FirstEnergy Corp (NYSE:FE) 3%
Telecom BT Group (NYSE:BT) 2%
Real Estate Jones Lang Lasalle (NYSE:JLL) 2%

With only 13 holdings, a surprising amount of diversification is achieved. All the stock sectors are represented, and in approximate weighting to their market cap in the S&P 500. There is a 60/40 split between domestic and international exposure. There is roughly a 70/20/10 breakdown between large cap, mid cap, and small cap stocks. As you might have guessed, I tend towards both value investing and dividend investing in my single stock selection. That portion of the portfolio has a forward PE of 12.8 and a dividend yield of 3.6%, compared to the S&P 500 which has a forward PE of 17.7 and a dividend yield of 1.9%.

This past week, the nightmare scenario unfolded for one of these stocks when Kroger suffered its biggest one day drop in decades and an even bigger weekly loss. It lost 18% in one day and 30% for the week. Despite this once in a century price drop, it caused a drag on the total portfolio of only 1.5% for the week. This is because I didn't overdo it with beaten down retail names, despite the fact that a number of them look like good values right now. And while it turns out I didn't pick a great one to own for this past week, I believe it represents an even better value now after the week's overreaction and I added shares during its decline.

While subtracting 1.5% from the weekly results of the portfolio due to a single stock is not pleasant, it doesn't move the needle by all that much. What might be frightening for a professional fund manager who has to justify his performance each day and quarter to his investors and firm, is just not as important for an individual investor with a 25 year investing horizon. Most individual investors have two luxuries that professionals do not have: time and security. We don't have to worry about window dressing at the end of the quarter to keep our investing jobs and if we plan things right, all that matters is whether me meet our long-term goals.

As long as an investor is using money that he or she doesn't need in the near term, single stock risk is simply not that scary. And the single stock risk comes with single stock reward. If Apple ever suffers a 30% loss in a week like Kroger just did, it will hurt my portfolio twice as much. But in the meantime, Apple's 45% gain over the past 11 months has had an outsized contribution to the portfolio's overall performance, compared to a 13% gain for the S&P 500 over the same time period.

So is it too risky to have a single stock make up 10% of your portfolio? Since I have half of my portfolio devoted to the broader market and I have a long investing horizon, I don't think so. And while the latest Kroger stress test was tough, the portfolio withstood the shock quite well.

Conclusion

I personally believe that having an allocation to both diversified funds and a small group of individual stocks provides me with the best of both worlds. I am largely capturing the returns of the stock market with index funds, I am undaunted by fluctuations in a single stock, and I preserve the possibility of beating the market with concentrated bets on single stocks.

Disclosure: I am/we are long AAPL, F, KR, NYCB, TEVA, IMO, SSW, FBR, BT, FE, JLL, VTSAX, VTMGX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.