Diversification - am I enjoying too much of a Good Thing? Part 3 of 3

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Why is Diversity Good?

• I am sure most Readers will be fully aware that if you hold a bunch of Stocks, you have the advantage that gains from the good Stocks will outweigh the losses from the poor performing Stocks - obviously just holding 1 or 2 Stocks is pretty much suicidal. However, this of course is very much linked to the number of holdings - for example, if you hold just 5 Stocks there is a very real Risk that 2 of them could Blow-up badly and you will make a loss overall on the Portfolio (especially if you focus on Small Caps and AIM). Whereas if you hold 100 Stocks then you will pretty much just track the overall Markets and will have a Management/Administration nightmare. I have gone into this whole subject many times before in various Blogs so I won’t dwell much more, but probably the minimum sensible number of Stocks to hold is around 15 and probably 40 is really the maximum (that is lucky, cos I am aiming to get down to the WD40 !!). It is also my view that only very experienced and successful Investors can get away with holding just 15 Stocks - it is much more Risky than people realise and it just takes a couple of Errors to murder your Returns. As recent weeks in the Stockmarket have shown me mercilessly on Stocks like Entertainment One ETO, Telit Communications TCM, Utilitywise UTW, Brady BRY, Black Swans can swoop in at any time and cause devastation. I would bet that most people with extremely concentrated Portfolios massively over-estimate their Stockpicking and Portfolio Management Skills.

• The ‘Natural Hedging’ which comes from a Diverse Portfolio of Stocks as I have mentioned in the bullet point above, is one of Investing’s (and Trading’s) very rare ‘Free Lunches’ - it is silly to ignore its huge benefits when it has very little cost to pursue. You need no special Skills to diversify and there is no entry fee !!
• There were 2 recent examples on Thursday October 29th 2015 of why this Natural Hedging is so beneficial - the first was when Solid State SOLI issued a surprise Profit Warning and the Share fell something like 30% in one day. This caught a lot of people out because it had been an incredibly successful Stock for a period of perhaps a couple of years and had really run up a lot. Of course, for People with Portfolios which only held a small number of Stocks, as SOLI grew it became a larger and larger proportion of their Portfolio Value - so, once the ‘Black Swan’ event hit, their Portfolios got battered (a good reason to use a TopChopping discipline when Positions grow to a pre-determined Weighting in a Portfolio). A similar thing happened with Optimal Payments OPAY (now Paysafe PAYS) which got hit by a Customer Data Security Breach rumour (which turned out to be nonsense) and caused a drop of something like 22% at one point in the day (people using Stoploss Orders will have been closed out). I hold PAYS but because I have so many Stocks, it was a nuisance but it didn’t destroy my Portfolio. Since these events, I have taken a right kicking on Telit TCM - but again my diverse Portfolio means that my Overall Gains are near to All Time Highs even after the Sell-off in recent days. The Diversity I have also extends to sizes of Market Caps - this helped me when BRY collapsed as I only had a relatively small position.
• If you use Spreadbets for Leverage as I do, it is vital to have a Portfolio of Spreadbet Positions - the Natural Hedging is a total saviour when using such a Leverage Strategy.
• It is important to grasp that the only Result that matters on December 31st each year is the Percentage by which your Portfolio has grown (or whatever year end date you use) - the performances of the Individual Stocks that make up your Portfolio are irrelevant. If you use the Benefits of Diversification then you can have several total duffers in your Portfolio but still come out with a very good Overall Portfolio Result for the Year. Many people do not get this and as a result they stress and worry about why one of their Stocks has fallen 40% - it is a fact of life that many of your Stock Picks will not work out - it’s something you have to accept and use Risk Management Techniques (Stoploss, Position Size, Thorough Research, Diversity, Hedging etc.) to ensure that your Overall Portfolio does well, despite the odd Cock Up.
• If you hold too few Stocks the £ Value of any one Position can become very large with the result that if you need to sell fast, you may struggle to do so at a decent Price due to Liquidity issues - this really applies to Smaller Market Cap Stocks, especially those on AIM - you are unlikely to have this problem on FTSE100 stuff. Holding a lot more Stocks gives you the ability to find Liquidity amongst some of your Holdings if there is a desperate need to Sell anything because you need Cash - although you shouldn’t really ever get yourself into a position of being a Forced Seller.
• If you hold too few Stocks, it can all become really boring as there is nothing much to do. This could have an added Danger in that it makes you overtrade - because you are bored you could be selling things too early and chasing after buys that are ill-timed. This will hurt performance badly (especially when Dealing Fees, Stamp Duty and Spreads etc. are accounted for). An additional problem is that if you are fairly new to Investing, you will not gain much experience just by holding a small number of Stocks - if you have the Capital, you are better off holding more Stocks so you can learn what works for you and what doesn’t, and you can get a lot of experience of feeling the ‘Ebb & Flow’ of the Markets.

What are the Advantages of holding fewer Positions?

• As I hinted at in the ‘Why is Diversity good?’ Section, if you hold fewer Stocks in your Portfolio then you have a much higher likelihood of outperforming the Overall Markets. However, in truth, it is not this simple. What this really means is that as your Number of Holdings goes down, the Volatility of your Percentage Yearly Returns will increase - you are more likely to have really strong Years but you are also more likely to have really bad Years, than if you held a lot more Stocks. To a large extent it is about holding the appropriate Number of Stocks so that you are comfortable and able to manage them properly in terms of keeping up with their News, following their Charts, monitoring Targets, dealing with Admin and being alert to other possibly better opportunities etc. If you are emotional and jittery (this is very common in New Investors who lack experience which toughens you up), you might find that such Yearly Volatility in your Returns is just too scary and makes you feel uncomfortable - it is really important to build a Portfolio (and Invest/Trade) in a manner which suits your personality and psychological make-up. Maybe when starting out it is best to hold more Stocks and as time goes on and you feel more in control, you can reduce the number. If using Spreadbet Leverage, then a Volatile Portfolio with just a few Positions will be extremely scary and if you feel emotionally disturbed, you will probably make very poor, fear driven, (or greed driven) decisions.
• Obviously if you hold less Stocks the management tasks that I mentioned in the bullet point above become a lot easier. It is a trade off against how much Risk and Volatility in your Portfolio Returns you are happy to accept - and it may take a few years of experimentation before you really do settle on a Number of Stocks you are very comfortable with. Time available (when you are not at work or entertaining kids, entertaining pets or whatever) also comes into the equation.
• Fewer Positions also means fewer Trades are needed - this reduces your Overall Costs and will be a big benefit compared to a much larger Portfolio. For example, a Portfolio with perhaps 15 Stocks will have much lower Trading Costs in total for a given year than a Portfolio like mine with 45 Stocks. As I mentioned in my now infamous Compounding Blog (link below), even small amounts of Money like £30 can be worth many multiplies of that over a period of 15 to 20 years or so.

Conclusion - Current Answers to the ‘Am I Diversified too much?’ question
Having written this Series of Blogs and thought quite a lot about this precise question, I am coming round to the idea that I am perhaps a little bit too diversified. My previous intent to get down to the WD40 - i.e. to hold 40 Stocks in my Trading ISA Portfolio rather than the current 45 or so, is still in train and I am slowly, slowly, getting the number down. It is not easy because I do not want to sell great Stocks too early just to meet my WD40  Rule - especially at the moment when we are in the most Bullish part of the Year (ok, it might not feel like it this week !!) and I want to maximise my Gains over these last few Weeks. In the past probably the Number 1 Mistake I have made over and over is to sell Great Stocks way too early - I cannot stress enough how the Power of Upwards Momentum can drive even an apparently overvalued Stock on to extremely high levels - there is no point in missing out on this if you can stay in the Trade. Another Free Dinner.

Despite having a lot of Stocks, in practice, due to running and adding to Winners, I am Overweight on a number of Stocks and Underweight many others where they have not worked out as planned (yet). These effects mean that even though I have 45 Stocks, it is probably the case that 20 of them really make the difference to my Returns and some have very little impact - for instance, I only have about 0.75% of my Portfolio Exposure in Cello CLL so it has very little impact, whatever it does (this is prime candidate for getting ditched soon). However, my Tristel TSTL Weighting is probably around 5% so this has a big impact - much of it from the superb run up in the Share Price since I bought in. It is worth realising that in effect my Number of Holdings is not at all Static and it changes a lot even over fairly short periods of time.

My Income Portfolio is fine and I don’t need to do anything to it at this point. Maybe in the distant future when it grows in size I might need to go to a couple more Stocks - maybe up to 15 but I see no reason to hold any more than this. I want the WD Income Portfolio to be pretty much almost no effort and almost no activity - it is very much what I see as ‘Passive Investing’. Yawn.

If there is an Over Diversification problem it is in my Unit Trusts and it is probably here that I will take action. I am particularly frustrated this year because the Portfolios I manage myself are massively outperforming all of the Unit Trusts - and I get Divvys as well. I am tempted to ditch the European Unit Trust - I am not really sure what this is giving me - Europe Stocks are pretty much highly correlated to US Stocks and UK Stocks so it is all doing the same job really. Despite what I will go on to say in the next paragraph, I can’t help thinking Europe is a sclerotic Economy in terminal decline and a bigger fear is that the Euro could weaken against the Quid which would adversely impact my Returns going forward.

I am sure I have mentioned this before but I am of the view that Funds are best used to get exposure to a particular Theme or Sector (like I do on my Tech and Health Funds) but I am not convinced they are much use for exposure to Geographies / Countries - this is because the Economic Performance of Individual Countries is pretty much impossible to predict and because GDP and Stockmarket Returns are not related as people think. My current thinking is that Geographic Funds work only as a Basket where you use regular Rebalancing (probably once a year) and it is almost like gambling because you are just assuming that Stockmarket Trends for ever rising Indexes over time are going to continue - there is a lot of hope in this way of Investing and it is far Riskier than People realise. Anyone Investing in this way just before the Bubble Burst in 2008 will have felt the Risk very acutely, and would have no Downside Protection (apart from perhaps the odd Bond Fund which might have offset a little bit of their Loss). I am sure this is a topic I will be revisiting over time.

Something that I have been thinking a lot about lately is to take on more Leverage in my Spreadbet Account. Something I have learned this year is that my FTSE100 Hedging activities do work pretty well and saved my backside on August 24th 2015 when we had the horrible falls of ‘Black China Monday’. I am seriously thinking of increasing my Spreadbet total Long Exposure by as much as 25% more or even 50% more - this would be a big increase and potentially risky but it would still only be around a third of my Total Wealth. It’s a difficult one and I will not rush blindly into it - but shifting some Capital from my European Unit Trusts to use as Buffer in my Spreadbet Account to enable more Leverage would make sense.

I wrote the Paragraph above some weeks ago and I am typing this bit on Wednesday 9th December 2015 - just after 2 pretty tough Weeks on the Markets with some nasty falls. Funny how such Market behaviour impacts my thinking and emotions and I am now wondering if increasing my Spreadbet Exposure is quite so wise - when things are going swimmingly and your Accounts are rising in value nicely, it is just so very easy to forget how quickly the Black Swans can come flocking in and how things can turn Ugly extremely fast - if Over-leveraged, this would cause big problems. This is making me think that perhaps I could increase my Leverage by another 25% on Exposure over the course of 2016 but to just go mad and add 25% on January 1st 2016 would be a bit reckless. In addition, adding 50% more really is overdoing it I suspect.

For now, I am thinking I will sell my European Unit Trust completely, and take the Cash out to support a bit more Leverage if I want it and no doubt I can always spend Cash down the Pub.

I will continue to mull this over and when I do my Trading Plan / Rules Document for 2016 I will amend as I decide.

Lots of thinking still to do then, cheers, WD


Links to related WheelieBlogs:

Position Sizing:

http://wheeliedealer.weebly.com/blog/the-wheeliedealer-approach-to-position-sizing-part-1

My Spreadbetting Approach (this last part contains links to the earlier parts):

http://wheeliedealer.weebly.com/blog/how-to-use-leverage-safely-and-successfully-spreadbetting-and-cfds-part-7-of-7

My Averaging Down Blog can be found here:
http://wheeliedealer.weebly.com/blog/is-averaging-down-the-root-of-all-evil

The Compounding Blog is here:
http://wheeliedealer.weebly.com/blog/why-bother-investing-the-power-of-compounding