I often hear people say:
Buy shares in a great company and you will make money!
This is extremely dangerous investment advice. Outstanding returns will not come from simply buying shares in the world’s best performing companies.
- You should never forget that your returns will depend on the price at which the bought the shares– the discount to the shares’ market value. You can buy shares in the best-performing company in the world, but if you overpaid for its shares, you will not beat the market. Equally, you can make a lot of money from a mediocre (even insolvent!) company if you bought its shares at a low enough price.
- High-cap stocks are often more efficient. There is a much lower chance that you will find a bargain in high-cap markets, buying well-known stocks.
Please remember that investors tend to have an overly optimistic mentality in long bull market runs. As legendary investor Howard Marks describes in his book “The Most Important Thing”: in the 70s, investors thought it was acceptable to buy a bunch of blue chip stocks (see the Nifty Fifty) with prices at around fifty times P/E. They didn’t base their investment decisions on realistic valuations. Needless to say, these stocks massively underperformed over time and the market crashed in 1980. If you had invested in these stocks in the 70s, you would have lost most of your money by 1982. Don’t be the one to fall into this trap.
Please never tell friends/family and beginner investors to simply buy shares in great companies without doing the work by evaluating and monitoring the company’s share price and the company’s performance. If they aren’t willing to do that, investing in a low-cost index fund is perfectly acceptable.
Should diversification be pursued; and if so, to what extent?
Just a while ago I attended a short finance course as part of my law firm’s internal training. To my surprise (and to the unsurprising indifference of my peers), portfolio theory was part of the syllabus. As the lovely Indian lady began to brainwash us with the universally accepted ideas on diversification, I was anxious to release my inner value investor and challenge the dogma taught in business schools. Unfortunately, I didn’t get a chance to do so– hence this brief article.
Diversification reduces risk by combining investments. It’s important to differentiate systematic (market) risk from unsystematic (company-related) risk. The elimination of systematic risk (e.g. by short selling index options) is generally ill-advised because the market have always and will always go up in the long term. The elimination of unsystematic risk is a good thing as it lets you take a smaller hit if one of your investments fail — i.e. the positive performance of some investments can offset the negative performance of others.
Okay, but how many holdings should I have?
The more company-related risk, the more stocks you should hold. A certain amount of diversification should always be pursued, but it’s hard to find the sweet-spot. You may decide to buy one company’s stock which goes bust for reasons unforeseen or you build a widely diversified equity holding which is like an index tracker. Neither of these is ideal.
My main portfolio consists of cheap, volatile and illiquid, low-cap businesses, mostly in emerging markets. If your buying these cigar butts, lack of diversification is a bad move. In a similar situation, a portfolio of 8-20 holdings in different markets and industries would suffice, but you know what they say – different strokes for different folks.
In summary, the minimum number of holdings will be based upon your portfolio’s unsystematic risk profile and the maximum will be limited by how many you can take the time to monitor. In any case, holding at least 5-10 investments with low correlation is what you should be aiming for, regardless of your strategy.