In this episode we take a deep dive into diversification, and the perils of over and under diversifiying your portfolio. Mark shares two of his mistakes he made with his portfolio, and the lessons that he learnt from his experiences. 

Listen on:

Get more of Morningstar's articles in your inbox

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. It's been a big few weeks of sports, Mark.

Mark LaMonica: Are you talking about cricket?

Jayamanne: Well, I don't really want to talk about the cricket, so let's...

LaMonica: I mean, I don't know that much about cricket, but Australia murdered Sri Lanka.

Jayamanne: And there's another ODI today, which I don't think is going to go very well, although there's a lot of Aussies from the first-class team that are sitting out. So we'll see what happens.

LaMonica: Yeah, you know you're a good cricket team and you don't bring your good players to play in Sri Lanka.

Jayamanne: They came. They just after the first two, they were like, we'll just fly.

LaMonica: They're just on vacation.

Jayamanne: Yes. But let's not talk about the cricket because I don't want to talk about that. Let's talk about the Super Bowl. You watched it?

LaMonica: Yes, me and a lot of other people. It wasn't a very good game, but I hate Kansas City, so I'm happy they lost. So, since you don't know much about football, you know, that's Taylor Swift's boyfriend.

Jayamanne: I figured, yeah. I heard she was upset and they booed her.

LaMonica: Shocking. I feel like it's a Super Bowl. We film these things for people listening. Will set up lights probably to make me look better. But anyway.

Jayamanne: You feel like you're in the Super Bowl. Is that what you were getting at?

LaMonica: The Super Bowl of podcasting. But we've got an exciting episode today and not necessarily the topic, but because I just went off the reservation at 5 a.m. this morning and changed the topic.

Jayamanne: I think you do this to make me anxious.

LaMonica: Yes.Shani is very organized. I'm not organized. You have this whole spreadsheet and the spreadsheet has all the different topics. And for some unknown reason, every year, you create a new spreadsheet. And so, I put all these notes in the spreadsheet about topics that people write in and things like that. And you cleaned up all my notes. And when I looked at the episode we were supposed to do today, it just said pension.

Jayamanne: It said getting into pension mode. And it was a listener requested episode. So, if you were the listener that requested it, you can take it up with Mark. We're not doing that today.

LaMonica: But I copy the email in and you're getting into pension mode.

Jayamanne: Anyway, we're really giving people the detailed look into the minutiae of Investing Compass and how we operate.

LaMonica: Yeah. But today we're going to do something, tips on building a portfolio. Because it is a topic in general that people are very interested in. I feel like we don't do enough on that. And so, we're going to talk about the investment side of things. We talk a lot about structure. We talk about the goals process and coming up with an investment strategy. So, we're going to look at the investment side of things today.

Jayamanne: And as a reminder, that is setting a goal that's figuring out the return needed to achieve the goal and then picking an asset allocation that can get you the return you need to achieve that goal.

LaMonica: Right. And then you document your investment strategy. And that, of course, helps you pick the investments you have, make sure they're aligned to your goals, and it makes sure that you do not succumb to bad behavior.

Jayamanne: We've really just summed up our whole job in three sentences.

LaMonica: All right. Let's go get a martini then.

Jayamanne: So, let's start with diversification because part of building a portfolio is choosing how many holdings are in it.

LaMonica: Yeah. And so, obviously, this is very dependent on what you are investing in. So, whether that's individual shares or an ETF or a fund that's already diversified. But we're going to talk philosophically today about diversification.

Jayamanne: So, let's start with the simple purpose of diversification. And we're told diversification is to not put all your eggs in one basket. So, what do you think of that?

LaMonica: I mean, it's a nice little sound bite, right? It just doesn't tell us what to do. So, I'll talk about me. The reason I diversify is I want to remove single security risk from my portfolio. So, that's it. Nothing more, nothing less. That's my reason for diversifying.

Jayamanne: And single security risk is simply the risk that something bad happens with one share that you own. That something could be anything. It could be fraud at the company. It could be bad management decisions. It could be a competitor crushing them or new technology or something else that makes their product or service obsolete.

LaMonica: Yeah. And maybe you picked up on this. So, Shani said something bad happening. That is what risk is. And really what something bad happening in your portfolio is permanently losing enough money so that you can't achieve your goals. And that is my worry personally. That's why I diversify. And this is not, of course, a unique view on markets. I borrowed it from this guy named Warren Buffett. He's an obscure investor in the Midwest in the US.

Jayamanne: An obscure investor that we've based a drinking game around.

LaMonica: That is true. That is true. And what he talks about, he says that for each individual investment he makes, he's trying not to permanently lose capital. And what I've done is I've just taken that and put it on an overall portfolio perspective. So, we'll contrast this with the way that many investors approach diversification in a minute. But I want to use a real-world example for my portfolio. Now, this is a failure of mine, Shani. And I know that that makes you really happy.

Jayamanne: We're just going to do one failure today?

LaMonica: I mean, how long do you have? I do have a lot of failures, but this should be an exciting episode for you.

Jayamanne: Okay. Let's do it.

LaMonica: All right. So, I recently sold a share and I did that because it no longer fit my thesis for when I bought it. And I bought the share back in 2011. So, Shani, you were like four years old, like running around your parents' yard with your Nimbus, whatever, thousand brooms.

Jayamanne: Nimbus 2000. It was like a plastic broom.

LaMonica: And your parents bought it for you at a yard sale, right?

Jayamanne: A garage sale, they call it here.

LaMonica: Okay. Same difference. So, anyway, that's what you were probably doing in 2011.

Jayamanne: I mean, I was in university in 2011, so I hope not. But...

LaMonica: Okay. Well, there we go. Either way, I was buying Intel. And I won't go through the whole sad story of Intel, but Intel used to be a wide moat company. It paid a generous and consistently growing dividend. And it's basically fallen apart. So, they are in the technology business, obviously. They make semiconductors and they fell behind. Their competitors did a better job. They lost their moat. The shares have fallen 55% in the past year. And things haven't been going great for a while. So, I think I was probably too patient with Intel. But anyway, that's just kind of my approach.

Jayamanne: So, how...

LaMonica: Buy and hold investor.

Jayamanne: How bad was this of an investment for you Mark?

LaMonica: Well, so, I didn't actually lose any money. I will say that. I was up 10% when I sold it. The issue is, of course, I bought this 14 years ago. And obviously, people have seen what's happened in market. So, making 10% on a share in 14 years, especially these 14 years, is really, really bad. So, I would have made more money if I put that money into a savings account. So, the point is that if I invested my entire portfolio in Intel, I'd obviously be in trouble. So, for 14 years, I would have earned a return well below my required rate of return. I would have never accomplished my life goals because I didn't foresee basically all the other semiconductor, Taiwan Semiconductor, AMD, NVIDIA, just, kicked Intel's ass across the board in the semiconductor space. So, it's a good thing I was diversified.

Jayamanne: Yes. And the point is that by diversifying, Mark lives to fight another day. But he builds a portfolio to reduce the risk to his goals. So, that one or multiple of his investments, if they don't work out, then he's still okay.

LaMonica: I'm okay financially.

Jayamanne: We'll see.

LaMonica: In other words, not so much. All right. So, we want to contrast this, as we said. We want to contrast this with another interpretation of diversification. And that interpretation is that you own a bit of everything. So, you spread your bets far and wide.

Jayamanne: And I think we need to step back and think about the purpose of diversification. The purpose of diversification is to lower risk. The question is, what risk are you trying to lower and by how much? Let's start with this notion that you're trying to lower single security risk. If you own one share and you buy a second share, you've lowered risk. If you add another share, you've lowered risk further. And the same process goes on and on until you own every share and you've eliminated all single security risk. The question is, where do you stop? And it's hard to know this.

LaMonica: And then there's this other notion of what you're trying to do with diversification. And that is that you're trying to eliminate volatility. Now, we start hearing terms when we're talking about volatility. We start hearing terms like correlation. We are told that you should own shares and other investments that aren't correlated, which means their prices often don't move in the same direction. And that, of course, lowers volatility.

Jayamanne: So, now we're trying to eliminate single security risk and volatility. So, we have to own lots of each type of investment and we have to own lots of different types of investments. And things are starting to get complicated here. Taken to the extreme, a diversified portfolio is now owning shares in every sector, in every country, both developed and emerging, in every market cap from large companies to small companies to medium-sized companies. You own every type of bond and you own gold and crypto and everything else you could possibly imagine.

LaMonica: Yeah. And I think there are a couple of different points that we can make here. There's a trade-off for everything that you try and do. And what you are doing if you try and own everything is you are choosing to have a really complex portfolio. You have lots of different types of investments to keep track of. There are lots of different things that can be adjusted. That includes the asset allocation to all of these different asset classes, and then of course the actual investments within those asset classes. And there's a lot of temptation when your portfolio is this complex, there's a lot of temptation to tinker with it.

Jayamanne: Now, we don't think that people should tinker with their portfolios. We think that most people can improve their results if they just trade less. But even if you agree and that is your strategy, there's still a lot of work that needs to be done with a really complex portfolio. It is work you might have to do because you need to rebalance between all these different asset classes or it might just be extra work by making contributions to your portfolio and figuring out what to buy or figuring out what to sell if you're in retirement and you need to support withdrawals.

LaMonica: And of course, the big question is if volatility is a risk you're trying to remove is why are you trying to lower it in your portfolio in the first place? So for most investors, and we've talked about this a lot on here, for most investors with long time horizons, volatility isn't that important. So what you're really doing by trying to eliminate volatility is you're just lowering returns. And we'll walk through an example because examples are good, Shani. So shares have a correlation of 0.25 with market neutral funds according to Guggenheim, which is an investment management firm, not just a museum.

Jayamanne: There you go. And market neutral is a strategy where long and short positions are used to remove the impact of the overall direction of the market and instead returns come from the stock picking skills of the manager, both what they take long positions in and what they take short positions in.

LaMonica: So hearing that description, it shouldn't be surprising that there is a low correlation with just the market in general because you're obviously removing that market risk. But the question ultimately is what are you getting out of this? So Credit Suisse has an index that tracks market neutral hedge fund performance. And since the inception of the index in 2004, the average return has been 0.72% a year. So from a cumulative return perspective, the index is up 15.65% since 2004. The S&P 500 is up 683% over the same timeframe.

Jayamanne: And this is obviously an extreme example. But I do think that if you ever hear the sales pitch that an investment has a low correlation or negative correlation to one of your key holdings, you do need to take a step back and be a bit skeptical. If this investment is uncorrelated to something that goes up most of the time and goes up over the long term, you're likely doing yourself a disservice.

LaMonica: And if you are worried about volatility, and there are certainly some times when you want to consider volatility, I think you just need to think about how you do that. So you can lower the volatility of a share portfolio by owning shares that have lower volatility. So big, boring dividend payers with low business risk, for example, if you want to lower the volatility of your portfolio, you can do it with cash. I just wouldn't stray too far from what's simple, because as we said, there are going to be downsides to that.

Jayamanne: All right. So Mark, how do you diversify your portfolio?

LaMonica: Okay. So as I said, I try to remove single security risk. So I've got a little rule that I don't want a single share holding to be more than 5% of my total portfolio, or 5%, I guess, and 5% of the total income because I'm an income investor. So ETFs, as we said, they are already diversified. So I'm much more comfortable with a significantly larger percentage from an ETF. And I kind of make a ETF by ETF judgment call. So there's some ETFs that obviously track broad indexes. There are some that are in my case dividend ETFs that are a little bit narrower. I just try to think about if I could achieve my goals, if something went wrong with one of these positions. So in terms of everything else, I don't care. I don't try to have each sector represented. I don't really care about international diversification because I generally own large global companies. They do business all around the world. So it doesn't matter where they're listed or headquartered. I don't care about market cap. I just buy things that meet my criteria and focus on the long term.

William Ton: I am Will producer of Investing Compass and here are this week's must reads on Morningstar.com.au. In Mark's Unconventional Wisdom column he challenges the traditional classifications of income and growth stocks. He runs through his focus on dividend growth rather than just focusing solely on yield. Mark also runs through a controversial income pick that he believes offers significant potential for future dividend growth. Core satellite is an investment strategy that many financial advisors use for their clients. Shani looks at whether this is something that individual investors should adopt and whether she has adopted it for her own portfolio.

In the latest installment of his Bookworm column, Joseph uses David Dreman's concept of trigger events to explain NVIDIA's recent market fall. He also earmarks two ASX stocks that appear to lie on opposite sides of this famous contrarian investor's radar. With the vast amount of financial advice available through the media, individuals are often faced with an overwhelming number of investment options. As someone who works in the finance industry with an abundance of research at her disposal, Sim also experiences this paradox of choice. Despite this, her column explores why she chooses not to invest in individual stocks and why this aligns with her goals. Find these articles and more in the episode notes. Now it's back to Mark and Shani.

LaMonica: What about you Shani? How do you diversify? Or is this a private question?

Jayamanne: No, I think you're okay at asking that. I'm a little bit different. I don't buy individual shares and I just have a long-term strategic asset allocation that I do follow. But I also try not to overcomplicate things and I focus on things that are within my control. So asset allocation, tax fees, other costs, trying to minimize these costs that will impact my return outcomes is built into the decision-making process that I have to include or exclude investments. And I just ensure I know what I'm buying and I understand how it connects to what I'm trying to achieve.

LaMonica: All right. And there'll be a quiz at the end of this, by the way.

Jayamanne: For me.

LaMonica: Yes, of your favorite Mark failure story because we've got another one.

Jayamanne: Oh, God, all right.

LaMonica: I mean, I assume you're just going to pick the one that was the biggest failure.

Jayamanne: What was the biggest failure?

LaMonica: It's the story I'm about to tell.

Jayamanne: I thought you meant like all of your failures. I had to like reveal one that was my favorite.

LaMonica: Well, I guess you could do that too. I'm talking about the two failures we're talking about on this podcast. Okay. So this is a lesson for people who have been listening to this whole diversification thing and saying they don't think it's important or the lesson could be I'm just an idiot and they can do it better than me. But the notion here, if you are an anti-diversifier is you run this highly concentrated portfolio and really the idea is then your best ideas get more of your money and if they pay off you profit. But it's also a little bit dangerous.

Jayamanne: Okay. So tell us your story.

LaMonica: Okay. Here it come Shani. So my father-in-law spent his whole career at Citigroup and he was generous enough to over the years give my wife a couple shares each year as a Christmas present. So over time this built up and the shares appreciated significantly. So we got married, we combined finances and I looked at our overall portfolio and 15% of it was in a single company, it was in Citi. So I obviously knew this was a bad idea. I'm not an idiot. I would never build a position that large in my portfolio and I obviously could have easily fixed the problem. The issue is of course I didn't because the shares had a really, really low cost base and I didn't want to pay the taxes on the capital gains. So I knew there was something wrong. I didn't want to do anything about it. I just didn't want to face that downside of fixing it. So I sort of reasoned and justified my way out of it, which is what a lot of investors do when they know they're doing something wrong, you just justify it. And I just thought, okay, I'm young. I'll fix this problem with time. I'll save and I'll invest more and it'll slowly dilute this position. And this probably would have worked. The problem is of course this little event called the GFC. I don't know if you've heard of it, Shani. You might have actually been in a pram when that happened.

Jayamanne: I feel like I was a little old for a pram. I feel like there would have been a serious problem.

LaMonica: I don't know your parents' technique with raising you. I mean, I kind of do, but I won't share it on the podcast. But so anyway, of course, the GFC happened, Citigroup went off a cliff. The good thing is that capital gains problem I had when your largest holding goes down 97% in 18 months, you don't have to worry about capital gains.

Jayamanne: So how different do you think your life would have been if you hadn't made this mistake?

LaMonica: Yeah, it would just be crazy. I'd be on this podcast.

Jayamanne: I don't think you would be on this podcast.

LaMonica: Smoking cigars, lighting them with $100 bills.

Jayamanne: Well, you shouldn't do that in Australia. They're plastic.

LaMonica: That's true. That's true. What you guys need is some paper money. Yeah, I mean, it was a very expensive way to learn a lesson. I think the biggest thing was, and I think we say this all the time, you know, there's always this advice that like young people can take risks, like, oh, invest in whatever you want. Like, well, the problem is when you're young, what you're giving up when you lose money and what I gave up was time, right? There was all this time that that could have compounded. So yeah, I was in my 20s, there's a lot of time ahead of me. I'm still alive at 45. I might make it to 46, despite your predictions. But anyway, as I said, it was a very expensive mistake to learn and something I think about a lot.

Jayamanne: All right, do you have any more failures to share?

LaMonica: I mean, obviously, how long do you have? But why don't we leave it at two for today? So which was your favorite one?

Jayamanne: I'm going to say my favorite was the second one.

LaMonica: Because of how large the failure was.

Jayamanne: No, because it means that now you're sitting here and you're doing a podcast instead of somewhere on a yacht. Good for me, not good for you.

LaMonica: To be clear, it wasn't that large of a position, but sure, that's alternate life. I am on Sydney Harbor right now sitting on a yacht and who are you doing the podcast with?

Jayamanne: I don't know, Will. We could talk about crypto.

LaMonica: There we go. You'd be on a crypto podcast. It would have 20 times more listeners. And yeah, your life would be a lot better too. So it's really too bad. But anyway, thank you guys very much for listening to our impromptu podcast, impromptu topic. We really appreciate it. Any comments, questions you have taunting me about my failures, my email address is in the podcast notes.

Â