More than any single topic, I get a LOT of comments on my articles about ideal portfolio size (the age old ‘concentration vs. diversification’ debate). This is especially true of my extensive ETF holdings (about 50% of my total assets) where I own small pieces of many hundreds of companies. I suppose I’ve always tended to error towards over-diversification since I’ve internalized the ‘wisdom’ that I was taught as an undergraduate finance major about how diversification is the greatest thing since sliced bread. However, my professors also told me the market was efficient and never wrong, so I’ll delve open-minded into this subject that deserves deeper attention.
“Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.” -Phil Fisher, 1958
The case for a more concentrated portfolio has many nuances, but essentially comes down to this ‘if you have confidence in your picks, then increasing your number of holdings means you are adding weaker ideas that will dilute the returns from your winners.’ This is well summarized by a recent article by Sean Stannard-Stockton. You should read the article, but here is my main takeaway:
Source: Burton Malkiel via Sean Stannard-Stockton
“This chart is based on a study discussed in the book "A Random Walk Down Wall Street". The book, authored by Burton Malkiel in 1973, popularized the random walk hypothesis crafted by Eugene Fama in 1965. This hypothesis, which is joined at the hip to the efficient market hypothesis, says that stock prices move in an unpredictable manner so investors can’t outperform the market. What Malkiel’s chart shows is that as you add stocks to a portfolio, the volatility of the portfolio declines. This is what diversification is all about. But Malkiel fully acknowledges that even if you own every stock in the world, you can’t get rid of volatility. The best you can do is minimize the volatility of your portfolio down to the level of overall market volatility (labeled as “market risk” on the chart).”
The author concludes:
“So if your goal as an investor is to earn market returns, then wide diversification is exactly what you should do. But what if your goal as an investor is to outperform the market? Well, the only way to outperform the market, is to own a portfolio that is different from the market. What this chart shows (and remember, this data comes from one of the key proponents of efficient market hypothesis, not from someone arguing in favor of investors’ ability to beat the market) is that once you reach about 20-25 stocks in a portfolio you have captured almost all the benefits of diversification.”
Since this website is literally dedicated to Seeking Alpha (and I am committed to trying to achieve alpha in my portfolio over the long run), why don’t I limit myself just to my 25 best ideas? The answer, in part, is because I used to and I wasn’t satisfied with the outcome. Being this concentrated means that you must be correct in not only your higher level calls (choosing between factors, sectors, locations, etc…aka systemic risk) but you must then ALSO choose take on a lot of company specific risk (it isn’t enough to like pharma stocks or energy stocks, you have to know which ones don’t have a CEO that is embezzling). It means if you guessed wrong and were over concentrated in energy (like I was in 2015) or finance (like I was in 2008), then you will get hurt. But also that the individuals names you chose (SD or LEH versus KMI or GS) were the difference between getting killed or simply a long recovery. Frankly, I’m just not a good enough stock picker to survive even 20% of my picks going awry. However, I fully concede that if you are trying to hit home runs, then a concentrated portfolio is the only way to make those hits really count.
“Diversification is the only free lunch in investing.” -Harry Markowitz, 1952
The case for a more diverse alpha seeking portfolio also has many nuances, but essentially comes down to this ‘take advantage of small, but consistently demonstrated edges rather than bet the farm on a guess.’ This is well summarized by a recent article by Ben Carlson. You should read the article, but here is my main takeaways:
More than 50% of the S&P 500 turns over every 20 years, meaning the deck is stacked full of potential losers if you tried to pick a stock at random.
Maybe Chuck Palahniuk’s quote from Fight Club sums it up well.
“Two-thirds of all stocks underperformed versus the Russell 3000 Index from the time they were added to the index. And 40% of all stocks had negative absolute returns, suffering a permanent 70% or more decline from their peak value.”
In fact, it is a very few winners (that I believe are extremely difficult to identify without the benefit of hindsight), that dive all the returns.
“The percentage of extreme winners in the index was in the single digits, meaning a very small percentage of stocks carried most of the weight for the remaining underperforming stocks.”
However, Carlson doesn’t conclude that you have to only own the broadest index possible, instead he advocates that you need to have an edge. “Most assume picking the big winners is the key but it’s likely more important to somehow screen out or avoid those distressed stocks that can be so damaging to performance.”
In my own investing journey, I believe that a DGI philosophy (much in line with the factors propounded by Ploutos) that focuses on diverse holdings with a persistent edge will win the race in much the same way that the tortoise beats the hare. Because I can’t say with any confidence exactly which company will win, so I would rather just own all of them that fit within a proven mold. I think that ETFs that skew towards higher dividend paying/growing stocks with low valuations/volatility can be a tremendous asset over the long haul. I guess we’ll just have to see, but I sleep better at night knowing that I am not one crooked CEO away from financial ruin.
April 2019 Review
April 2019 was a good month for domestic equities overall, though my portfolio disappointed with only a 0.5% return versus the 4.0% return of the S&P 500. However, my 5.3% forward dividend yield on invested capital keeps crushing the less than 2.0% yield of the broader index…so it’s tough not to give in to FOMO but I’m about where I would expect to be after a big run up in asset prices (as my value focused picks tend to lag growth stories during big rallies).
April 2019 rewarded me with realized dividends of $963 (versus $854 in 2018…an increase of 13%!). For the last 12 months, my portfolio delivered $14,572 in cash to me (up 4% from 2018). My realized yield for the trailing twelve months was 4.9% for my full portfolio including cash reserves. I’m also making progress towards my 2019 goal of over $15,000 for the year (a 15% increase over 2018). Fear and greed are hard to balance, but I am happy with where I am overall. My yield focused strategy still makes the most sense to me as paper gains may come and go but cash is forever!!
Since I write for Seeking Alpha primarily to improve my own investment portfolio, I think it is important that you know my objectives. Please consider this context when you look at any advice I give and form your own opinions based on your needs and desires.
- GOAL: Attractive, risk-adjusted, absolute returns (5-15% annually) over a long-term time frame while minimizing capital loss and extreme drawdowns.
- STRATEGY: 'Enhanced' dividend growth or DGI strategy that focuses on a core of diversified high yielding holdings (ETFs and individual companies -- my general screening criteria: growing companies (YoY EPS growth >0%) with attractive valuations (PEG <1.5 and P/E <20) and strong and safe dividends (yield >4%, payout <90%, and market cap >$500MM)…no tobacco stocks or micro caps), supplemented with return enhancing tools like hedges (derivatives and shorts), commodity exposure, etc., as well as some crazy picks.
- BALANCE: Blend of ETFs (domestic and international) and individual companies (where there is a compelling reason to own). Seek to not overweight any one sector unless there is a compelling reason to do so (although the nature of these investments leads me to be overweight in traditional dividend paying sectors like financials, REITS, and energy).
Note: I violate these guidelines constantly, so please call me out on it!
Portfolio Composition as of April 30, 2019
|Security||Type||Div Yield||Market Value||Last Month Value||Gain/Loss(%)|
|Oppenheimer Ultra Dividend Revenue ETF (RDIV)||ETF||3.7%||$15,540||$15,156||2.5%|
|SPDR S&P 500 High Dividend ETF (SPYD)||ETF||4.3%||$15,436||$15,136||2.0%|
|Fst Tst Dow Jns Glbl Sel Dvd Idx ETF (FGD)||ETF||5.5%||$12,080||$11,655||3.6%|
|PowerShares S&P 500 High Div Low Volatility ETF (SPHD)||ETF||3.9%||$8,530||$8,492||0.4%|
|SPDR S&P International Dividend ETF (DWX)||ETF||4.6%||$7,956||$7,798||2.0%|
|FlexShares International Quality Dividend Defensive (IQDE)||ETF||5.0%||$6,691||$6,633||0.9%|
|Invesco S&P International Developed High Dividend Low Volatility ETF (IDHD)||ETF||4.6%||$5,580||$5,534||0.8%|
|UBS ETRACS 2x US High Div, Low Vol ETN (HDLV)||ETN||10.1%||$5,487||$5,636||-2.6%|
|iShares Nasdaq Biotechnology ETF (IBB)||ETF||0.2%||$5,321||$5,590||-4.8%|
|iShares Evolved U.S. Innovative Healthcare ETF (IEIH)||ETF||1.4%||$5,002||$5,199||-3.8%|
|VictoryShares Emerging Market High Div Volatility Wtd ETF (CEY)||ETF||5.0%||$4,880||$4,820||1.2%|
|Invesco S&P Emerging Markets Low Volatility ETF (EELV)||ETF||5.3%||$4,848||$4,810||0.8%|
|Horizons NASDAQ 100 Covered Call ETF (QYLD)||ETF||11.1%||$4,580||$4,540||0.9%|
|iShares MSCI China Small Cap ETF (ECNS)||ETF||5.3%||$4,558||$4,553||0.1%|
|iShares Asia/Pacific Dividend ETF (DVYA)||ETF||6.0%||$4,385||$4,309||1.8%|
|iShares MSCI Australia ETF (EWA)||ETF||5.5%||$4,354||$4,304||1.2%|
|IQ 50 Percent Hedged FTSE Europe ETF (HFXE)||ETF||4.1%||$3,957||$3,798||4.2%|
|Global X MSCI Portugal ETF (PGAL)||ETF||4.3%||$3,324||$3,245||2.4%|
|iShares International Select Dividend ETF (IDV)||ETF||5.7%||$3,169||$3,086||2.7%|
|iShares MSCI Malaysia ETF (EWM)||ETF||3.8%||$2,971||$2,994||-0.8%|
|Global X MSCI China Comm Services ETF (CHIC)||ETF||0.2%||$2,762||$2,558||8.0%|
|Blackstone Mortgage Trust (BXMT)||REIT||7.0%||$10,677||$10,368||3.0%|
|Royal Dutch Shell (RDSB)||Company||5.8%||$9,734||$9,593||1.5%|
|Tanger Factory Outlet REIT (SKT)||REIT||7.7%||$9,030||$10,490||-13.9%|
|New Residential Investment (NRZ)||REIT||11.9%||$8,640||$8,692||-0.6%|
|Sabra Health Care REIT (SBRA)||REIT||9.3%||$6,572||$6,542||0.5%|
|Iron Mountain (IRM)||REIT||7.6%||$6,496||$7,092||-8.4%|
|General Mills (GIS)||Company||3.9%||$5,147||$5,175||-0.5%|
|Cardinal Health (CAH)||Company||4.0%||$4,871||$4,815||1.2%|
|Ford Motors (F)||Company||5.8%||$4,180||$3,512||19.0%|
|KKR Real Estate Finance Trust (KREF)||REIT||8.5%||$4,034||$4,004||0.7%|
|PacWest Bancorp (PACW)||Company||6.0%||$3,955||$3,830||3.3%|
|Kinder Morgan (KMI)||Company||5.0%||$3,656||$3,682||-0.7%|
|People's United Financial (PBCT)||Company||4.1%||$3,458||$3,375||2.5%|
|Gilead Sciences (GILD)||Company||3.9%||$3,252||$3,251||0.0%|
|Occidental Petroleum (OXY)||Company||5.2%||$2,944||$3,307||-11.0%|
|VARIOUS POSITIONS OF <$2,000 VALUE||VARIOUS||2.0%||$4,053||$4,083||-0.7%|
|FIXED INCOME TOTAL||5.0%||$26,646||$25,890||2.9%|
|Goldman Sachs (GS) - Pref D (GS+D)||Pref||5.2%||$5,931||$5,772||2.8%|
|Bank of America Corporation (BAC) - Pref L (BML+L)||Pref||4.4%||$4,392||$4,200||4.6%|
|Morgan Stanley (MS) - Pref A (MS+A)||Pref||4.9%||$4,048||$3,870||4.6%|
|Goldman Sachs (GS) - Pref A (GS+C)||Pref||5.0%||$4,008||$3,924||2.1%|
|Goldman Sachs (GS) - Pref A (GS+A)||Pref||4.9%||$3,888||$3,804||2.2%|
|WisdomTree BofA Mrl Lynch HYBd ZrDr ETF (HYZD)||ETF||5.5%||$2,359||$2,325||1.5%|
|WisdomTree BofA Mrl Lynch HYBd NgtDr ETF (HYND)||ETF||5.4%||$2,020||$1,995||1.3%|
|SCHWAB ROBO-ADVISOR TOTAL||2.0%||$13,015||$12,690||2.6%|
|TOTAL + CASH||$21,817||4.9%||$329,842||$327,892||0.6%|
Portfolio Moves in April 2019
SHARE BUY– Canon (CAJ) : Bought 100 shares of this imaging hardware company at $29.25 on Apr 2.
- Reasoning: I love the strong yield (5.2%)… but the company has had a brutal year and might be a value trap.
SHARE BUY– Invesco S&P Emerging Markets Low Volatility ETF (EELV): Bought 100 shares of this EM dividend ETF at $24.05 on Apr 2.
- Reasoning: I love the valuations and long term growth prospects in the emerging markets, but I think EELV is a better mousetrap (5.3% yield and 0.29% net expense ratio) than EDIV (3.25% yield and 0.49% net expense ratio)… note: both trades were commission free on my Schwab account.
SHARE BUY– People's United Financial (PBCT): Bought 200 shares of this U.S. bank at $16.85 on Apr 8.
- Reasoning: A range limited stock, I liked the yield (4.2%) and the low payout, but I’ll probably sell when the stock gets back near $20.
SHARE BUY– PacWest Bancorp (PACW): Bought 100 shares of this U.S. bank at $38.25 on Apr 10.
- Reasoning: A range limited stock, I loved the yield (6.2%) and the low payout, but I’ll probably sell when the stock gets back near $55.
SHARE BUY– Occidental Petroleum (OXY): Bought 50 shares of this oil and gas E&P company at $66.05 on Apr 12.
- Reasoning: After a brutal decline that brought the stock near multi-year lows (despite solid fundamentals and a rising price for oil), I picked up OXY for its 5% yield and recovery potential…then they went out and bid the farm for Anadarko, so it’s too early to tell if I made a horrible call (but right now I’m wishing I had bought VLO instead).
SHARE SALE– Schwab U.S. Dividend Equity ETF (SCHD): Sold my last 100 shares of this dividend ETF at $52.59 on Apr 1.
- Reasoning: I still love this ETF but the yield has fallen under 3%, so I took profits with a 17% gain and will buy again once the yield rises (aka the price falls).
SHARE SALE– SPDR S&P Emerging Markets Dividend ETF (EDIV): Sold all 300 shares of this EM dividend ETF at $32.13 on Apr 1.
- Reasoning: The yield had fallen below 3.25% (and this ETF has 0.49% net expense ratio), so I locked in a 48% gain and switched my EM dividend holdings to EELV (which has a 5.3% yield and 0.29% net expense ratio)…note: both trades were commission free on my Schwab account.
SHARE SALE– Franklin LibertyQ International Equity Hedged ETF (FLQH): Sold all 100 shares of this international dividend ETF at $24.95 on Apr 1.
- Reasoning: The yield was nice at ~5%, but this ETF just doesn’t seem to have gone anywhere…so I cashed out with a 0.5% profit and will look for better opportunities elsewhere.
Portfolio sizing is always going to be as much art as science, but all parties agree that successful investors must develop a perspective (based on data and their skills) and stick to it. If you have no idea why your portfolio has the number (or weighting) of the stocks that it does, then you need to have a serious think about what strategy you want to pursue.
So me, I think I’ll continue my strategy of widely diverse holdings with factor tilts that I believe in, enhanced by concentrated bets on my best ideas. This is partly why my ETF dividend yield is only 4.7% versus my individual company yield of 6.2%; however, as evidenced by this month’s gain of 1.2% in my ETF holdings and loss of -1.5% in my individual company holdings, I sleep better knowing my broader ETF holdings can help balance my lack of experience/luck/skill in my individual company selection. In the end, there is some merit to the argument that a part-time investor can really only follow so much at one time, so I try to limit my portfolio to 50 positions (but I still own many hundreds of companies).
With a hat tip to Jeff Miller at NewArc Investments whose ‘Weighing the Week Ahead’ is the single most valuable thing I read every week, I will separate my thoughts into two buckets: ‘Could Be Signal’ for front of mind topics and ‘Probably Just Noise’ for things in the press that don’t bother me much at this point with regards to how it might impact equity markets.
Could Be Signal:
- Elevated U.S. valuations versus low corporate growth expectations (what the market chooses to focus on will likely guide market performance)… so far the ‘beat rate’ seems to be winning
- Negative equity fund flows leaving corporate buybacks as the only major bidders
- Disappointment from trade talks with a probability of a cease fire rather than a settlement
Probably Just Noise:
- Yield curve inversion (wait, is this a thing people are still worried about?!)
- Fed rate changes (my best bet is that we end the year at the same place where rates are today)
- Anything 2020 politics (it’s just too early and governance has a way of moderating firebrands)
Disclosure: I am/we are long ALL STOCKS AS MENTIONED. 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.
Additional disclosure: The author is an amateur who has a history of getting calls both right and wrong with zero predictive power. Trade at your own risk and never rely solely on this author's opinion. Also, as I have no knowledge of your circumstances, goals, and/or portfolio concentration, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.