Throughout my almost 30 years in the financial industry, the subject of diversification has always interested me.

It is an important topic because individual investors have been exposed to several conflicting messages. It seems to me that institutional investors have taken an almost comical approach of using too much diversification, while individual investors often take an overly risky and financially dangerous approach by holding concentrated portfolios.

The big Wall Street firms want their clients to be widely diversified—limiting the chance of a client’s portfolio “blowing up”—while continuing to collect their annual management fees. In my opinion, you do not need to give in to planned mediocrity. You can both eat well and sleep well. The key is to assess your own tolerance for the short-term volatility that comes with trying to generate higher returns and then build and manage a portfolio accordingly.

Concentrated Versus Diversified

There are two well-known sayings that apply to investing:

• “Don’t put all your eggs in one basket,” and
• “Put all your eggs in one basket and watch it carefully!”

Both of them cannot be right for you. The nerve-wracking emotions that surface in volatile markets can knock you right off your long-term plans if you can’t handle sudden downdrafts. It is just as easy to get too aggressive on the upside, concentrating in only a few securities while they are rising in value. Of course, we hear of the great returns generated by Warren Buffett by shunning diversification and focusing on just a few quality names. Peter Lynch, the great mutual fund manager from Fidelity, coined the colorful expression “de-worse-ification.” The word pokes fun at holding too many positions and asks how many poorly run unprofitable companies an investor would like to add to his or her portfolio in the name of diversification.

Be careful when hearing about someone’s successes with concentrated portfolios, however. For every big winner, there are countless stories of those with less fortunate results.

I am not one to encourage investors by saying how easy it is to make money in the stock market. Particularity—investing in small-cap companies and having highly concentrated portfolios—can be risky. There are so many great-sounding “stories” that it is all too easy to get caught up in ideas that never materialize. Even when there is a sound product, a good business plan and even a good management team to execute the plan, so many things can and often do go wrong. This is not intended to sound negative or to discourage individuals from investing in the stock market or focus their efforts in just a few companies. Rather, it is just to point out that are significant risks involved.

“If you can buy more of your best ideas, why put [the money] into your 10th best idea or 20th best idea? … The more positions you have, the more average you are.” —Bruce Berkowitz

Back in my Statistics 101 class, a professor put up a standard “bell curve.” As simple as it was, I found the concept remarkable. According to the law of large numbers, when any group in nature is measured, 68% of its components will fall into an average range of readings (Figure 1). There will be about 5% far below and far above average. This applies to the height of trees, the weight of automobiles, the IQs of people, baseball players’ batting averages, golfers’ handicaps, and pretty much anything measurable, including the profitability of investing in public companies. Although there are many facets to the concept of the bell curve and its statistics, this is the basic theory.

For example, I used to take the subway from Manhattan to the Bronx High School of Science. One of the stops along the way was Yankee Stadium. As we would pass the stadium, I would think about Babe Ruth, Lou Gehrig and Mickey Mantle. I would also think about how many kids grow up and want to play in the big leagues. How many ever make it to the major leagues? How many people bat .350 for a season or hit 40 home runs in a year? We are talking about the cream of the crop. Despite their best efforts, only a few people run 100 meters in under 10 seconds. How many people ever score 40 points in an NBA game? This is the way public companies can be thought about as well.

Figure 1. Likelihood of Being Average,
Extremely Good or Extremely Bad

 

Diversification: Built on Overly Flawed Simplistic Math?

The early mathematical studies that introduced and promoted diversification were overly simplistic. Modern portfolio theory (MPT) was original introduced back in the March 1952 issue of The Journal of Finance, when Harry Markowitz wrote “Portfolio Selection.” At the time that Markowitz introduced his concept, the financial markets basically consisted of two alternatives: stocks and bonds. The idea behind MPT was to have a disciplined strategy mixing the right blend of securities in a portfolio, based on a given risk profile. Theoretically, the blend would provide the optimal combination of risk and reward. It was little more than trying to find an “efficient frontier” to determine the optimal risk/return blend. Researchers readily admitted at the time that they did not have enough computing power to address much more.

Today’s world of derivatives, hedging, ETFs (exchange-traded funds), international currency markets and high-speed trading is obviously more complicated. The more appropriate questions that can be addressed are:

• What is the optimal number of holdings to be properly diversified?
• How much short-term volatility is removed as more holdings are added to a portfolio?
• What is the impact on the ‘terminal value’ of a portfolio based on the level of diversification?

One of the ways I try to control volatility and continue to generate high returns is by adjusting the level of securities in my portfolios and the level of concentration of companies within a given sector. I illustrated this in my book “The MAGNET Method of Investing” (John Wiley & Sons, 2009) by demonstrating the use of the MAGNET stock selection process within the S&P 500.

First, all 500 companies were ranked through my process and put into scored order. From there, several approaches were taken. Clearly, as I reduced the number of holdings in a model portfolio, the approach continued to move further away from the direction of relative performance and closer to providing a more absolute return.

Holding fewer securities in this case clearly moved the portfolios further up the volatility scale, but the added returns justify the approach. While there is still no absolute number that is optimal, I personally believe that 25 to 35 securities provides the risk/reward and volatility that I am comfortable with.

The Actual Securities Held Matter Too

“It is a funny thing about life; if you refuse to accept anything but the best, you often get it.”—W. Somerset Maugham

It is not enough to decide to own stocks; the right ones need to be identified. In each environment, there are always a few companies that dominate their niche business and are great stocks to own at that time. The difficult thing for many investors is that often the best companies to own are not household names yet.

Because of the sheer size of most of the mutual funds, it is only after a huge run up in price or several years of continued expansion and stock splits that companies become ‘large and liquid enough’ to become eligible as institutional holdings. The individual investor can be nimble enough to find and invest in companies before the institutions can buy them.

Over his or her lifetime, an individual investor needs only to identify a few small companies that end up blossoming to accumulate real wealth. Remember though, anyone who is willing to focus their capital on only a few small-cap companies better have a methodology to identify the right ones.

It is a well-known fact that each bull market is led by new names. Often, even if an investor could time the market perfectly, unless he or she can identify the true market leaders, the end result may be frustration with the returns. Rarely do fallen leaders of the last bull market regain their strength when the next upswing takes place. While many trends seem to repeat themselves in the stock market, there is nothing more profitable than identifying the best individual stocks at the right time.

The tough part for many investors is that market leadership invariably changes in and throughout each new bull market. Without having a way to identify new market leaders, there may be a tendency for a good market timer to identify exactly when a strong market period presents a good opportunity, only to invest in a company that does not participate in the rally. Investors need to understand that they can regain their confidence and embrace individual stocks by isolating companies they can trust and feel comfortable with—if even for only a few years at a time. The hardest concept to understand is that most of the best companies do not stay good investments forever.

Using the quantitative MAGNET stock selection process, I rank all companies based on 19 carefully selected metrics that blend the best aspects of value, growth and momentum. Sorting and ranking by revenue growth, profit margin growth, free cash flow and several proprietary ratios, I attempt to identify the strongest companies at the moment. Companies with these characteristics often attract capital and then pull in the institutional investors. Once companies get sufficiently large and need to live up to excessive expectations and valuations, the upside becomes limited. MAGNET is an acronym that represents the pillars of my stock-picking philosophy:

• Management must be outstanding, and the stock must have momentum.
• Acceleration of earnings, revenues, and margins is essential.
• Growth rate must exceed current valuation.
• New product or management may be the driver.
• Emerging industries or products create great opportunities.
• Timing needs to be technically opportune for price appreciation.

AAII has been tracking two screens, MAGNET Simple and MAGNET Complex, based on a discussion we had in 1998. [Editor’s Note: The screens can be accessed in the Stock Screens section of the AAII website at www.aaii.com/stockideas.] One of the reasons it is so fun for me to write this article is because I have personally gotten a lot out of AAII’s stock screens over the years. Each month I enjoy seeing which companies pass through the various screens, including my own. There is a treasure trove of knowledge to be gained from studying the returns of the contrasting styles during the various market environments. Naturally, I also root for the screens based on my process to outperform the other models. Comparing my personal returns to the theoretical picks generated by AAII’s monthly rebalancing has been fascinating to me.

Because I have been in the market for so long and seen cycles come and go, I stress the need to stay on top of one’s investments. I do constant diagnostic checkups on my holdings by carefully following certain balance sheet and financial data.

When an investor understands the nature of global competition, he or she must realize that companies cannot stay on top indefinitely. While market-leading companies gain the attention of investors, they are also being watched and copied by their competitors. To simply believe that a company can continue to earn higher margins than their competitors and maintain market share over time is to ignore history. Some may survive generations, while others will flame out more quickly. In less-diversified portfolios, it is even more important not to allow any one position to fall too far.

The screens that AAII has been tracking for MAGNET Simple and MAGNET Complex mirror my diversification beliefs and behavior, but to an extreme. The AAII screens are so restrictive that only two to three companies pass the criteria in an average month. As a fiduciary within a registered investment advisory, I tend to manage portfolios with 20 to 30 positions—what I consider as ideal in the trade-off between generating high returns and maintaining an acceptable level of volatility.

A portfolio with only 25 positions is considered a concentrated portfolio in the institutional world. I believe an individual investor who is willing to accept more volatility can work with a portfolio of seven to 10 stocks. In a forthcoming issue of the AAII Journal, I will provide an updated version of the MAGNET screens designed so that at least seven to 10 companies pass in a fairly valued market. If less than a dozen companies pass through the updated model, then the screen might be telling us that current valuations are just too high.

Avoid Being Overly Diversified

It may not be easy or always achievable for everyone, but higher returns are possible.

One thing I hope I made clear is that anybody looking for higher-than-index returns needs to avoid the very thing that keeps most investors mired in mediocrity: over-diversification. By now most investors understand that they cannot achieve long-term financial goals (or at least goals requiring the growth of capital) in fixed-income securities. Make sure to supplement your reading outside the narrow focus of financial periodicals. Remember, most economists do not make great investors.

My main message is that, as in all aspects of life, there can only be a few true superlatives. Isolating the best stocks to own and focusing on them is the way to make real money in the stock market.

Investors who go the route of broad diversification are assured to generate only average returns. At the same time, using a professional money manager who acts as a closet indexer by holding, say, over 100 stocks, and who produces average returns that match the market at best is unnecessary. Individual investors would be better off in a low-cost index fund.

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