- You might be concerned that you are holding too much Apple stock (rightfully so) with its market capitalization approaching $3 trillion.
- Is it time to de-Apple, to reduce the concentration risk, and to better diversify?
- Ray Dalio called diversification the “Holy Grail of Investing” for good reasons. However, the subtleties and fundamental limitations are often ignored.
- This article will examine the fine line between diversification and deworsification, and show it’s never a good idea to diversify just for the sake of diversification.
Thesis and Background
In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing” and made the following comments about this chart:
That simple chart struck me with the same force I imagine Einstein must have felt when he discovered E=mc2: I saw that with fifteen to twenty good, uncorrelated return streams, I could dramatically reduce my risks without reducing my expected returns… I called it the “Holy Grail of Investing” because it showed the path to making a fortune.
Source: Ray Dalio’s Principles.
Diversification probably is the first concept that every investor learned. And the above chart is indeed a very powerful chart, and most of us surely understand the key message here – and the message seems to motivate the questions that we started with:
- Should you be concerned that you are holding too much Apple stock (NASDAQ:AAPL)?
- Are you exposed to too much concentration risk with your AAPL positions?
- Should you trim your AAPL positions and better diversify?
However, as with many other powerful tools, diversification is prone to be overused and even misused. So it is the goal of this article to examine this powerful tool closely and answer the above AAPL related questions.
AAPL: how much are you holding?
Firstly, you need to understand how much APPL you are actually holding. The following chart shows the weight of AAPL in some of the most popular indexed funds. As seen, as of this writing, Apple is about 11%+ of the NASDAQ index (represented by QQQ), about 6.6% of the S&P 500 index (represented by VOO), about 5.5% of the US total market fund (represented by VTI), and about 3.3% of the total world market fund (represented by VT).
Are such levels unprecedented for one stock in a broad index? Yes, they are. As we enter our information age, for better or worse, the powerful network dynamics created certain winner-take-all market sectors. And the emergence of dominant mega-players is simply inevitable.
Are such levels alarming? No. Firstly, it is more of a personal preference - I feel very comfortable parking a few percent of my overall asset on one stock. And secondly, as we will see later, the additional benefits of diversification are quite marginal to hold 50 stocks with 2% weight each vs holding 10 stocks with 10% weight each. In this case, even if QQQ is the only fund that you hold, your exposure to AAPL is only 11.3%.
Of course, if you have other exposure to AAPL (like AAPL shares themselves) in addition to these index funds, then you should first review your inventory and see how much you are actually holding.
Diversification: the Holy Grail’s limitations
After you get an accurate inventory of your APPL shares, let’s see the often-neglected subtleties of diversification.
First subtlety – are they correlated?
The first key subtlety is the correlation among your holdings. Let’s read Dalio quote again (and this time I've added an emphasis below):
I saw that with fifteen to twenty good, uncorrelated return streams, I could dramatically reduce my risks without reducing my expected returns
The operative word is that these return streams have to be uncorrelated to effective diversity. Most of us understand that choosing different stocks within the same sector (like holding 20 banking stocks) does not help to diversify. However, many of us probably are not too aware that stocks across different sectors are quite correlated to each other, and that correlations impact diversification too. The chart above shows that when the stocks are correlated, the marginal benefits of holding additional stocks decrease quite quickly. Let’s examine this more closely. Say if we have a large set of stocks that are 20% correlated with each other. As can be read from the following chart, picking 10 of them already captured more of the benefits there is to be captured by diversification, as illustrated by the green arrow on the left hand. Adding more stocks does little to help, because there is a little left to be captured anymore (as illustrated by the blue bar on the right-hand side).
As the correlations among the stocks decrease, the additional benefit would increase. But as you can see from the chart, even if the correlations decrease all the way to zero, holding 10 of them will already capture most of the benefits of diversification (the orange arrow vs the purple bar).
So what is the actual correlation among stocks then? The answer is that they are typically more than 20% correlated with each other.
So for better or worse, in reality, no matter how many stocks you hold, the additional benefits of diversification are quite marginal beyond about a dozen or so (that is why Dalio mentioned 15 to 20 himself).
Source: Author based on Ray Dalio’s Principles.
Second subtlety – are they good?
The second subtlety is these ideally uncorrelated streams need to be “good”. Holding 5 A-grade stocks at 20% weight each is better than holding 5 A-grade stocks plus another 5 B-grade stocks at 10% weight each. This is the fine line between diversification and deworsification. Replacing some of your AAPL shares may not help your better diversify because of the correlation issue mentioned above. Furthermore, it may actually increase your risks if the replacement is worse than AAPL even your portfolio seems to have more holdings with more equal weights on the surface!
So do you have replacement ideas that are better than Apple? I am sure there are stocks out there that are better than AAPL (whether we can find them or not is a different issue).
However, it’s never a good idea to diversify just for the sake of diversification and it is quite hard to find better replacements for AAPL. Because, as to be seen next, AAPL is far better than most of the stocks in the aforementioned indexes. Simply reducing AAPL and adding other stocks most likely will lead to deworsification rather than diversification.
Diversification or deworsification?
The next chart shows a comparison of the fundamentals between AAPL and the S&P 500 index. The chart compares them in terms of valuation, financial strength, and profitability. Firstly, as you can see. The valuation of AAPL is only slightly higher than the overall market, by about 4% in terms of the PE ratio. In terms of the EV/EBIT, AAPL is actually valued the same as the overall market because of its lower debt ratio as we are going to see next.
In terms of financial strength, AAPL is far superior to most of the businesses in the S&P 500 index. Take its debt coverage as an example. Here the debt coverage is defined as EBIT income divided by net interest expenses (“IE”). It is about 25.2x for AAPL, compared to less than 10x for the S&P 500 index.
In terms of profitability, AAPL again is far superior to most of the businesses in the index. Its operating margin and net profit margin are, respectively, more than 2x and 3x better than the average of the index. Let’s look beyond the forests and look further into the trees. Among all the subsectors consisting of the S&P 500 index, the technology sector (represented by the SPDR fund XLK) and the communication services sector (represented by the SPDR fund XLC) currently have the highest net profit margin. As shown in the second chart in this section, their current net profit margins are 19.1% and 13.3%, respectively. Such margins are indeed significantly better than the overall S&P 500 index. However, APPL’s margin is just far too superior even when compared to these most lucrative sub-sectors. And a thick margin by itself is a wide and stable economic moat.
So the overall picture is pretty clear here – AAPL is no more expensive than the overall market but it offers far superior quality. Funds (especially passively indexed funds) seem to be a dead-end to me already for the reasons just said. In terms of individual stocks, your odds of finding better replacement stocks for AAPL are also slim given that A) AAPL is so superior to the overall economy or its subsectors, and B) the whole economy and its subsectors are made up with individual stocks.
Source: author based on data from Multpl and csimarket.com.
Source: author based on data Seeking Alpha and Yahoo Finance
Conclusion and final thoughts
Ray Dalio called diversification the Holy Grail of Investing for good reasons. However, the subtleties and fundamental limitations are often ignored. When these subtleties are applied specifically to AAPL, the main takeaways are:
1. For better or worse, no matter how many stocks you hold, the additional benefits of diversification are quite marginal beyond about a dozen or so. And AAPL is no exception here (with its scale and reach, it is probably more correlated to other stocks than average).
2. Furthermore, to effectively diversify, you not only need uncorrelated stocks, but they need to be “good” too. Replacing some of your AAPL shares may not help your better diversify because of the correlation issue mentioned above. Furthermore, it may actually increase your risks if the replacement is worse than AAPL even your portfolio seems to have more holdings with more equal weights on the surface. In AAPL’s case, it is no more expensive than the overall market but it offers far superior quality, posing challenging odds of finding better replacements.
3. However, there are definitely good reasons for some investors to de-Apple. Different investors have different risk tolerance levels, and some investors may just hold too much of it. For investors who really to de-Apple, here are a couple of ideas:
- You could consider replacing some of the indexed funds mentioned above (e.g., QQQ and VOO) with RSP. It is the Invesco S&P 500 Equal Weight ETF and it offers an equal weight indexing of the 500 stocks in the S&P 500 index. So AAPL’s weight in this fund is only about 0.2%. By mixing RSP with your other funds, you could tailor your exposure to AAPL.
- If you hold AAPL shared directly, you could consider replacing some of the AAPL shares with Berkshire Hathaway (BRK.B) shares. As argued in my earlier article here, this replacement could help you in two ways. First, you effectively reduce your AAPL exposure by about 60% because each BRK.B share contains “only” 0.4 AAPL shares. And secondly, it might also reduce your ownership valuation of AAPL (to about 12x PE as argued in my earlier article).
- Last but not least, do consider tax complications when you switch positions too. In non-tax-sheltered accounts, your replacement ideas not only have to be better than AAPL, they have to be at least about 20% better to overcome the tax alone (assuming the average federal and state tax rates on capital gains). Depending on your specific situation, buying a put option might end up being a more cost-effective way to hedge your AAPL position rather than trim/replace it.
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This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.
Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL either through stock ownership, options, or other derivatives. 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.
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