Diversification – Back to Basics

Diversification may be the most important word when it comes to finances. It can also be explained by that old saying, “Don't put all your eggs in one basket.”

Diversification of income, asset classes, geography, and risk are all things that I've built into my financial life. In fact, some have accused me of going crazy over diversification but I believe it's absolutely essential. Read on to hear how the White Coat Investor addresses this concept of diversification within his portfolio.

This article is republished from the White Coat Investor. You can see the original post here.

This is another post in my back to basics series.  More than anything else, investing is about managing risk.  A wise investor is constantly juggling risks-market risk, manager risk, interest rate risk, inflation risk, risk of regulatory and tax changes, etc etc.  It goes on and on.  After a while it starts making malpractice risk look like a piece of cake.

One of the most important risks for an investor to manage is single company risk.  This is the risk that any given company pulls an Enron, or a WorldCom, or a Borders, or a NetFlix (down from $300 a share to $130 a share in the last 2 months since they decided to start charging more.)

The best way to manage individual stock (or bond) risk is to diversify.  This means to never put all your eggs in one basket.  Now, Warren Buffett might say “Put all your eggs in one basket and watch that basket closely”, but in reality he doesn’t actually do that, does he?  (Berkshire Hathaway currently holds 27 different stocks.) So if even Warren Buffett, perhaps the greatest stock-picker known to man, past or present, doesn’t put all his eggs in one (or even two or three) baskets, why do you?

Mutual funds provide a great way to diversify among individual stocks.  They are not allowed by law to have more than 5% of their holdings in any given stock.  That means if a company whose stock the fund owns goes bankrupt, the worst your fund will do is lose 5%.  Most funds don’t have any stock that makes up 5% of its holdings.

I was reading an annual report today for Bridgeway’s Ultra Small Company Market Fund.  They don’t buy into any position with more than 0.5% of fund assets.  Vanguard’s Total Stock Market Index Fund holds 3324 different stocks with the largest being Exxon Mobil (2.7%) and Apple (2.1%).

Here are the biggest errors I see in portfolios with respect to diversification and how to solve them:

Taking on too much individual stock or bond risk.

Avoid this by using mutual funds, or, if you must buy individual securities, limit them to 5-10% of your entire portfolio (your “play money).  If you must hold more than this, make sure no more than 1-2% of your entire portfolio is invested in the stocks or bonds of any given corporation.  Individual stocks do go to zero.  Bonds do default.

Not holding enough asset classes.

Avoid this by holding assets that act differently under different economic conditions.  Diversify both among major asset classes (such as stocks, bonds, cash, real estate, and commodities) and within them (such as international small stocks or inflation-protected bonds).  You don’t need to become an asset class junkie, and the law of diminishing returns definitely applies to adding new asset classes, but I suggest that everyone own at least some stocks and at least some bonds, and any major asset class that makes up more than 25% of your entire portfolio ought to be divided into various minor asset classes.

For example, if your portfolio is 60% stock, you probably need to make sure you own some international stocks and small stocks, whereas if your portfolio is only 20% stock, a single asset class such as US large stocks is probably adequate.

Putting your job and your portfolio into the same basket.

Ideally, you never want to lose your job and your retirement at the same time.  The income of most physicians, while not recession-PROOF, is generally recession-resistant.  This allows them to take on significant market risk in their portfolios, i.e. invest in companies or countries that aren’t necessarily recession resistant.  Many in the corporate world are given, or encouraged to purchase, the stock of their own company in their 401K.

Remember the Enron sob stories from the people who lost their jobs when Enron went bankrupt?  Some of them were really sad because their entire 401K was composed of Enron stock.  That’s about as dumb as betting your life savings on red at the Roulette table.  Physicians generally don’t have this problem, but they can have a similar issue.

Hospital-based physicians can often times buy syndicated shares of their hospital.  The hospital corporation offers these to incentivize docs to work hard and bring business to the hospital.  But if a huge chunk of your retirement is invested in the same hospital you work at, you’ve got a diversification problem.  If the hospital goes bankrupt, your group may dissolve and you’ll be out of a job and a retirement, just like the Enron folks.

Likewise for a doc who owns his own practice.  If you’ve put a lot of your money into the practice or the building it operates out of in the hopes that you can sell it when you retire, you could potentially lose both at the same time.  Employed physicians should avoid the stock of their employer like the plague.

Over-diversification

Some people become collectors instead of investors.  They are generally buy and hold types, with the emphasis on buy.  Every time Forbes comes out with a “10 Hot Stocks to Buy Now” issue they buy those 10 stocks, but never sell the last 10 they had.  Some investors own dozens, or even hundreds of different stocks and mutual funds.  When they finally analyze the portfolio, they realize they have eight different mutual funds that invest in the same asset class.

A portfolio containing eight large cap growth mutual funds is NOT better diversified than a portfolio containing one large cap growth fund and one small value fund.  These investors tend to spread their money around so many institutions, accounts, funds, and individual securities that they unnecessarily complicate their finances, pay more taxes than they ought to, pay more commissions and fees than they ought to, and often times get WORSE diversification than a simpler portfolio would provide.

This diagram from BehaviorGap.com (recommend a visit by the way) demonstrates how this works.

Not diversifying among Fama-French factors.

Eugene Fama and Kenneth French have described a model of the stock market where there are three risks- market risk, value risk, and size risk.  More recently, some academics have suggested that there is another independent risk factor-momentum.

If your portfolio relies only on market risk, then perhaps you are not as diversified as you could be.  A total market portfolio (such as the default portfolio I’ve discussed in the past) suffers from this lack of diversification.  (To be sure, this type of diversification is far less important than the types addressed above.)

You can add this type of diversification to your portfolio by “tilting” it to smaller and more “valuey” stocks by buying a small stock fund, a value stock fund, or even combining the two and getting a small value stock fund.  There are even funds that are trying to take advantage of the momentum factor such as Bridgeway’s Small Cap Momentum Fund, but the jury is still out on whether this strategy is a good idea or not.  Suffice to say, keeping costs low will be critical.

Remember that you need not have a complicated portfolio to have a diversified one.  Simple, yet elegant, solutions such as the Vanguard Target Retirement Funds are out there.  For example, the Vanguard Target Retirement Income Fund holds thousands of US stocks, international stocks, nominal bonds, inflation-protected bonds, and cash, all in one fund with a low minimum ($1000) and for a very low price (0.17% per year.)  But if your portfolio is mostly Google and Apple, (or heaven forbid your hospital corporation) or if you own 30 different mutual funds, it’s time to make some changes.