Picking better eggs and baskets

In this wire, we discuss building a diversified portfolio without sacrificing on returns. Not only is it essential to diversify your eggs across different baskets, it’s equally important to make sure you’ve got concrete eggs and steel baskets.

Focus on defense, but don’t forget about your offense

Given the current focus on regulation and risk management stemming from the Royal Commission, it’s not surprising to see most funds err on conservatism with their approach to investing. Willingness for fund managers to deviate from industry norms with asset allocation or stock selection is at all time lows. I’d like to highlight that there is nothing wrong with this approach. In fact it’s perfectly understandable given there is no incentive for salaried fund managers to punt one’s career unnecessarily. It’s safer to stick with commonly accepted mainstream trends. However the result of this is herd behaviour often represented by portfolios with an over-diversified soup of stocks that closely resemble an index Exchange Traded Fund (ETF). You’d expect to be getting average returns if you’re sticking to the herd.

Whilst the focus on risk management is important, there are many ways to achieve this without blindly increasing the quantity of stocks in your portfolio. For enterprising investors, just because you’re focusing on downside protection doesn’t mean you should lose focus on your offensive game. We’re here to make money. So we need to find the optimal trade-off between risk and return. I’d proffer this balance is not optimal in a portfolio with hundreds of stocks. So what’s the right balance? Here’s some food for thought below.

You are already life-diversified

From a life perspective, you are most likely quite diversified already. If you own a home or investment property, you already have significant exposure to property. If you have an offset account with your mortgage, you will already have exposure to interest rates. If you have a mainstream superannuation account you will most likely be highly diversified already - ‘balanced’ funds typically hold thousands of investments across all asset classes. If you run your own business, then you have already dedicated significant personal funding and time to one equity investment. If you’re employed full-time, your wealth is strongly linked to your employer and the industry they’re in.

As you can see, even before you’ve started actively investing, you will likely have exposure to specific asset classes and industries. When it comes to stock market investing, you should consider filling the gaps in your life. For example, if you’re employed by an Australian company, focus internationally. Start by looking for stocks in different geographies and industries for companies that you aren’t already exposed to.

Your customers will protect you

The stocks in your portfolio have customers and these people and businesses are your customers too. They are the ones who will protect you from the next downturn.

Your customers should be widely dispersed across the world. Your customers should also be diversified across multiple industries and product lines. The trap that professional fund managers fall into is they become sector specialists. They become biased towards one industry with a concentrated set of customers. As an individual investor, you have the freedom to float across industries and capture the most loyal customers of each country in each sector.

For example, Fuchs Petrolub (FPE.DE) is a boring family-owned company in Germany. It also happens to be the largest independent lubricant manufacturer in the world. Fuchs makes custom lubricants for industry-critical machines. They service customers all over the world in all industries ranging from manufacturing, auto, aviation, construction and racing. For as long as friction exists, there will be a need for lubricant. By investing in just one company, you’ve accessed a loyal global customer base diversified across geographies and industries.

Think of the underlying customers in your portfolio as adding a layer of reinforcement to the shells of your financial eggs, and giving you further protection against a falling market.

The false comfort of quantity

Conventional practitioners of diversification are uncomfortable with a portfolio consisting of a small number of stocks. They believe there is a magic minimum number of stocks they must hold which will protect their portfolios from any downside. In reality it is the quality of your holdings which is far more important than the quantity. As we saw in the Global Financial Crisis (‘GFC’), when markets crash, all stocks crash. It doesn’t matter how many you hold.

Quality companies are the ones that will bounce back quickly from downturns. These companies have loyal customers and their products or services will always remain valued by society. They will continue to generate profits through any macro environment. Quality companies will have a prudent attitude towards debt so are unlikely to default.

Instead of focusing on reaching a magic number of companies in your portfolio, focus on the goods or services each company offers. Focus on the quality of their product offering. How essential to society are their products and services? A quality company will have customers continuing to buy their products through any cycle.

Concluding remarks

The mainstream approach to diversification states that purchasing a large number of different stocks is the safest and best-performing choice regardless of market conditions. Followers of this approach seek to build a financial safety net by gathering together many stocks. The trap here is that over-diversification of your stock portfolio is neither an effective safety net in difficult times nor an optimal growth strategy in good times. While it is sensible and valuable to seek a variety of investments, there comes a point when blindly adding to the quantity of different stocks you own does little or nothing to improve the quality of your portfolio.

Remember, your ultimate aim as an investor is to make money in a way that effectively balances risks and returns. Rather than following the conservative herd, you should begin by looking at your stock portfolio within the context of your financial life as a whole. Avoid the temptation to acquire ever-increasing numbers of stocks. and devote yourself to seeking a limited number of high quality companies.

The aim of a well diversified portfolio is to serve as wide a range of loyal clients as possible by investing in as small a number of companies as possible. Rather than focus on more eggs and more baskets, focus on choosing concrete eggs and steel baskets.  

Happy compounding.