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.
The best way to manage individual stock (or bond) risk is to have a diversified portfolio. 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%). [Update 9/2018- Note these percentages have changed since this post was originally written.]
Here are the biggest errors I see in portfolios with respect to diversification and how to solve them:
5 Errors Keeping You From a Diversified Portfolio
1) 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.
2) 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.
3) 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 time 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.
4) Overdiversification
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.
5) 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. [Update 9/2018- since this post was originally written, hundreds of factors have been described. Time will tell which are actually real.] 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, 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.
What do you think? Have you made some of the diversification mistakes I mention above? Comment below!
“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?”
The number of holdings is only part of the story. Indeed, it appears that concentration is a key factor in Buffett’s success.
“We find that Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value. ”
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=806246
Yes, concentration IS a key factor in Buffett’s success. But it has been a key factor in the financial demise of far more people.
A much larger factor in Buffett’s success is that he not only invests in a business, but has a big say in how that business is run after he invests in it. In essence, it would like a doc investing in his own practice. Sure, it isn’t very well diversified, but the doc has an exceptionally large degree of control in ensuring its success. Putting 1/3 of your portfolio in Apple won’t give you that kind of control. Without the control, concentration is pretty foolhardy IMHO.
Concentration, rather than wide diversification, also requires the individual investor to use a lot of effort to make decisions. It takes precious little time, effort, and knowledge to just buy all the stocks with a low-cost index fund. If you have to just choose 3 of the 8000 US stocks, it requires a lot more of those three things, which are in short supply among physicians tired from a long call. Do you increase your chances of being filthy rich? Perhaps. But you certainly increase your chances of never retiring because one or two of those three stocks went bankrupt.
Well, Netflix has bounced back nicely and then some.
Question about the job + portfolio mixing: How risky do you feel 457 plans are? I have read that if the company goes under, the money invested could go with it. Can you shine some light?
https://www.whitecoatinvestor.com/non-governmental-457-plans-friday-qa-series/
Great article. But, you state: “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.” I’ve never heard this before and I don’t think this is accurate. I looked up several actively managed and passively managed mutual funds and found several that have holdings that exceed 5%. Can you point to the law that you are referencing please? Thanks, Micah
My understanding is that rule comes from the Investment Company Act of 1940. This link explains it well:
https://www.securitiesce.com/definition/6113/75-5-10-diversification
But I don’t know where in the Act it actually says that. I’ve never actually read it. But I’m sure I’ve read the 5% rule somewhere. Wish I could tell you were.
Better info here, citing chapter and verse: https://www.investmentfundlawblog.com/resources/investments-by-funds/investments-investment-companies/
Oh, here it is. Section 12(d)(1)(A) on page 43 of the Investment Company Act of 1940:
https://www.db.com/tcr/docs/Investment_Company_Act_1940.pdf
(d)(1)(A) It shall be unlawful for any registered investment
company (the ‘‘acquiring company’’) and any company or companies
controlled by such acquiring company to purchase or otherwise acquire
any security issued by any other investment company (the
‘‘acquired company’’), and for any investment company (the ‘‘acquiring
company’’) and any company or companies controlled by such
acquiring company to purchase or otherwise acquire any security
issued by any registered investment company (the ‘‘acquired company’’),
if the acquiring company and any company or companies
controlled by it immediately after such purchase or acquisition own
in the aggregate—
(i) more than 3 per centum of the total outstanding voting
stock of the acquired company;
(ii) securities issued by the acquired company having an
aggregate value in excess of 5 per centum of the value of the
total assets of the acquiring company; or
(iii) securities issued by the acquired company and all
other investment companies (other than treasury stock of the
acquiring company) having an aggregate value in excess of 10
per centum of the value of the total assets of the acquiring
company.
So I guess those funds you found are violating the law. Maybe call the SEC on them eh?
Thank you. I was just curious because I’d never heard of that rule. I’m mostly invested in ETFs but I do own one mutual fund. Many ETFs have over 5% in individual holdings. Maybe this rule doesn’t apply to ETFs and/or index funds. I appreciate you finding me that reading material. Micah
Ah, so now it’s becoming much clearer to me. So, I own some funds that are considered diversified and some that are not. For example I own some single country and some sector funds that are considered non diversified. This has been a great learning experience. Thank you. Micah.
New military attending here. Yes, lower income. I am a radiologist and make about double my military salary moonlighting. When I am elligible to get out I will be 40 and have 8 years to military retirement. I am not sure I will stay active duty (die richer vs. financial independence sooner with more miserable prime years). We have 250,000 sitting in the bank and I have met with a couple “financial advisors” thinking I would put the money somewhere. Everytime I meet with someone, I feel like I walked away from a used car salesman. I have likely unfounded fears of investing the money now when the market is “high” and continue to drag my feet. We live a very modest lifestyle and drive beaters until they fall apart. Married with three kids and don’t have much time to think about this. Wife doesn’t work and is not good with money (although doesn’t make as many painful irresponsible expenditures of many other physicians wives I have seen). I am looking for an easy solution to just do better, not perfect, just better.
You referenced a Vanguard retirement account above. I just want one account or fund I can drop all my money in and not think about it and be adequately diversified. Would a fund such as the “Vanguard target retirement fund” suffice in your opinion? I will max a sepIRA and my wifes IRA and we already max our TSP since graduating residency.
Thank you.
Signed,
Trapped military physician.
I’ll bet meeting a real financial advisor would be worth your time and money. Here’s my list:
https://www.whitecoatinvestor.com/financial-advisors/
More on target retirement funds here:
https://www.whitecoatinvestor.com/7-reasons-i-dont-use-target-retirement-funds/
More on SEP-IRA vs i401(k) here:
https://www.whitecoatinvestor.com/sep-ira-vs-solo-401k/