Diversification or Diworsification (15 Diversified Portfolios Review)

Key Concepts

• Diversification: Spreading investments across various assets to reduce risk.
• De-diversification (Concentration): Reducing the number of holdings to focus on high-conviction investments.
• Market Risk: The risk of losses due to factors that affect the overall performance of financial markets.
• Dollar Cost Averaging (DCA): Investing a fixed amount of money at regular intervals, regardless of market conditions.
• Return on Invested Capital (ROIC): A profitability ratio that measures how effectively a company uses its capital to generate profits.
• Return on Capital Employed (ROCE): Similar to ROIC, measuring profitability relative to the total capital invested.
• Economic Moat: A sustainable competitive advantage that protects a company's long-term profits and market share.
• FOMO (Fear of Missing Out): An anxiety that an exciting or interesting event may currently be happening elsewhere, often aroused by posts seen on social media.
• Value Investing: An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
• Alpha: A measure of an investment's performance relative to a benchmark index.
• Uncorrelated Assets: Assets whose price movements are not related to each other.
• Fed Put: An informal policy where the Federal Reserve is perceived to intervene in markets to prevent significant downturns.
• Intrinsic Value: The perceived or calculated value of an asset.
• P/E Ratio (Price-to-Earnings Ratio): A valuation ratio of a company's current share price compared to its earnings per share.

Analysis of Diversified Portfolios and the Case for Concentration

This video critically examines the concept of diversification in investment portfolios, presenting numerous examples of highly diversified portfolios and arguing that excessive diversification can hinder wealth accumulation. The core argument is that while diversification can protect against ignorance, it often leads to market-like returns, which may not be sufficient for achieving significant financial goals over the long term, especially in expensive markets. The presenter advocates for a more concentrated approach, emphasizing the importance of knowledge, fundamental analysis, and focusing on the drivers of returns.

Portfolio Examples and Observations

The video analyzes several investor portfolios, highlighting common patterns and potential pitfalls of over-diversification:

• Caleb's Portfolio: Described as an "educational portfolio" for a 22-year-old medical student. It includes ETFs (suggesting market-like performance) and individual stocks like Lululemon and Google. The presenter views this as a good learning ground for understanding investment drivers.
• Portfolio 2: Characterized by a large number of positions, many with small allocations (e.g., 1-2% for Nike, Tencent, Booking). The key question raised is the benefit of such small positions, as even significant gains would have a negligible impact on the overall portfolio. The presence of high-quality companies with attractive valuations is noted, but the sheer number of holdings dilutes their impact.
• Monthly Investment Portfolio (£550 into ETFs, £300 into UK stocks): This portfolio features a diversified core of ETFs (S&P 500, All-World, Gold) and a stock market portfolio with winners like Alibaba and Meta. Despite individual stock successes, the overall portfolio return is capped at 26% due to extreme diversification. The presenter states that exceeding 10 positions generally leads to market performance.
• Defensive Portfolio: Includes emerging market debt, cash-like assets, gold, and individual stock bets (Vestas, Mundi, Berkshire, Archer Daniels Midland). The presenter questions the impact of small positions like Berkshire (4.6%) and notes that cash, while a diversifier, loses value.
• Member's Portfolio (Incorporating Research Platform Ideas): This portfolio shows success with some individual businesses but remains extremely diversified. The central question is about the "driver of returns."
• Portfolio Moving Towards Value: This example illustrates a gradual shift from extreme diversification towards value-oriented businesses. The strategy involves buying companies with better earnings and equity, focusing on compounding rather than just stock price appreciation. The presenter suggests that less successful bets will naturally shrink as a percentage of the portfolio over time.
• Portfolio with Large Holdings (Berkshire, Google, Alibaba): This portfolio has significant allocations to well-performing stocks (up to 18% for Berkshire). The strategy of letting winners run is acknowledged as potentially acceptable, but the inclusion of numerous smaller, diversified plays is questioned.
• Portfolio with Expensive Holdings: This portfolio includes Berkshire, Daily Journal, and Alibaba, with a concern that holding expensive assets increases risk, especially if the market crashes.
• Extremely Diversified Portfolio with 16 Large and 150 Smaller Positions: The presenter questions the purpose of 150 small positions, even with a few winners, and their benefit to the overall portfolio. The inclusion of S&P 500 puts as a hedge is mentioned, with the understanding that these hedges are expected to lose money.
• Dividend Portfolio (£1.3 million): This portfolio focuses on yield, aiming for an average of 4.5%. The strategy is to reinvest dividends into lower-priced assets during downturns. The emphasis is on monthly earnings rather than the total portfolio value.
• Portfolio with High Gross Dividend Yield (5.2%): The presenter cautions against focusing solely on nominal dividend yield without understanding the underlying risk.
• Portfolio with Big Winners: The question of selling winners is raised, emphasizing the need to understand the original investment thesis and the driver of returns (dividends, earnings growth, P/E ratio).

The Theory and Practice of Diversification

The video delves into the theoretical underpinnings and practical limitations of diversification:

• Ray Dalio's "Holy Grail": Diversification is defined as finding uncorrelated assets with the same yield to achieve less risk for the same return. However, the presenter argues that finding such assets is difficult, and Bridgewater's All Weather portfolios have not performed exceptionally well due to low yields across asset classes.
• Diversification as Protection Against Ignorance: The presenter quotes that diversification makes little sense for those who know what they are doing. While acknowledging Ray Dalio's genius in managing billions, he contrasts this with Warren Buffett's investment philosophy.
• International Diversification: The presenter suggests that international diversification has become less relevant, with most global markets moving in tandem, except for specific local crashes. He points to the S&P 500 (excluding Nvidia) as a key benchmark.
• Dollar Cost Averaging (DCA): DCA is presented as a beneficial strategy, especially when buying consistently from a list of good businesses, particularly during downturns.
• No FOMO Benefit: Diversification can alleviate the fear of missing out by allowing investors to have small positions in various assets (e.g., Bitcoin), making them feel "cool at the table."

The "Ugly" Side of Diversification and the Case for Concentration

The video strongly argues against excessive diversification, highlighting its negative consequences:

• Market-Like Performance: With more than 10-20 stocks, portfolios tend to perform like the market, limiting upside potential.
• Detrimental in Negative Markets: While beneficial in bull markets, extreme diversification can lead to greater losses during market downturns.
• Dilution of High-Conviction Bets: Small positions in even great companies have minimal impact on overall portfolio returns. For example, a 1% position doubling only adds 1% to the portfolio.
• Increased Risk in Expensive Markets: In an overvalued market, diversification can increase overall risk by spreading capital across many expensive assets.
• Peter Lynch's "De-diversification": The concept of "de-diversification" is introduced, suggesting that adding lower-quality assets to a portfolio actually lowers its overall quality.
• Gamble vs. Investment: Positions representing 1-2% of a portfolio can become gambles. A doubling of such a position might only add 1-2% to the portfolio, while a crash could lead to a significant percentage loss of that small allocation.
• Focus on Drivers of Returns: The key question for investors should be the fundamental driver of returns (earnings, compounding, dividends) relative to the price paid, especially when markets are expensive.
• The "Fed Put" and Government Intervention: The presenter notes that government intervention (e.g., Fed buying stocks) can artificially prop up markets, but this is not a sustainable long-term investment strategy. The Bank of Japan owning 5% of its stock market is cited as an extreme example.
• Historical Market Crashes: The video references historical market downturns (e.g., a 51% drop after a decade) to illustrate the potential for prolonged periods of negative returns, which can erode investor faith.

Strategies for Solving the Diversification Problem

The presenter offers actionable advice for investors seeking to move towards a more concentrated approach:

• Knowledge is Key: Concentration requires understanding what you are doing.
• Build a New Value Investing Portfolio Slowly: Investors can maintain their existing diversified portfolio while gradually building a new, more concentrated one.
• Let Better Investments Take Over: Over time, the better-performing investments in the new portfolio will naturally grow and eventually outweigh the older, less successful ones.
• Follow Companies and Build a List: Maintain a watchlist of 20-30 stocks and increase positions in the best ones over time.
• Focus on Fundamentals: Prioritize earnings, compounding, and the price paid for an investment.
• Warren Buffett's Approach: The example of Buffett's portfolio, with significant early stakes in companies like Geico (50%) and Washington Post, is presented as a model for concentration.
• "Pound on It": Once a great investment vehicle is found, the advice is to invest significantly in it.
• DCA and Learning: For those who don't yet know what they are doing, the recommendation is to continue dollar-cost averaging, adding to the portfolio, and learning.

The Presenter's Own Portfolios

The presenter shares his own investment approach:

• Diversified Personal and Model Portfolio: This is an "educational portfolio" designed to generate ideas. It has performed in line with the market over the past year, with some individual stock successes (e.g., Alibaba up over 100%). The strategy involves taking calculated risks on promising opportunities.
• Model Portfolio (Started 2018): This portfolio, with monthly contributions, has nearly doubled its money in about three years, driven by dividends, earnings, and compounding. The focus is on the quality of businesses and a target of a maximum 40% allocation to any single position.
• Personal Portfolio (All in One Stock): This represents an extreme form of concentration. The long-term plan is to diversify over time by consistently buying the best available investments each year.

Conclusion and Takeaways

The video concludes by emphasizing that the "driver of returns" is paramount. For investors aiming for significant wealth accumulation, excessive diversification can be detrimental. The key is to build knowledge, identify high-quality businesses with strong fundamentals, and concentrate capital in those convictions. While diversification can offer protection, a more focused approach, backed by thorough research and a long-term perspective, is presented as the path to achieving substantial financial goals. The advice is to either continue dollar-cost averaging and learning if unsure, or to gradually transition towards a more concentrated, value-driven strategy once sufficient knowledge is acquired.