Unsimplifying Diversity in Investing

Normally I am a big fan of simplifying investment concepts, because I think that people who peddle investment information try to hold onto their relevance by making topics more difficult than they have to be. Big investment companies talk about the massive number of metrics they look at without telling you that most of the metrics add nothing to the prediction, and can actually lead astray. However, oversimplifying is not much better, and I wanted to discuss another way to think about diversity.

I will make a 1 paragraph TLDR at the end for those of you that do not want to read a long exhaustive article on diversity.

I am not counteracting any well established principles of diversity, but when I was taught about diversity it always ended up being overly broad. It was asset classes and sectors. These are very large categories, and I understand that the models and concepts imply diversity within the categories. I just wanted to shine some more light on this, because I think it gets short shrift. Diversity works at multiple levels.

The Common Approach to Diversity

Diversity is a way of reducing risk by spreading it around in the hope that returns can be maintained at reasonable levels. This is how I describe diversity as I was taught and how I read about it. I prefer to think about it as limiting catastrophic failures, though as I discuss at the end you really can’t protect against the downside of catastrophic failure. The point is that diversity is supposed to protect you from the risk of one stock.

Imagine flipping a coin with the risk of losing $1 per loss. The reward for winning is an unrealistic 10x. The reason I am not using the real odds is that you don’t bet on stocks like you’d bet on a coin or sports. It is possible for all your choices to come out a winner. Interestingly it is easier picking 10 stocks that are all winners (6%+ annual gains, which is a conservative return but solid), than it would be to call a horse race and properly guess the placing of each and ever horse. To account for this I am increasing the reward for the coin toss drastically.

You have only $1 since you pissed away all your other money on soda and cotton candy. Now you need money for insulin and a dentist. You can bet any amount you like. Would you bet your only dollar on one toss? Consider that if you put 10 cents per toss, each success would give you another dollar. Over the long run the tosses should be about 50% on each face. You are calling it in the air however, in this case it is perfectly random anyway so it doesn’t really matter. You can call heads every time and get near 50% over the long run. For our purposes just assume you got 50% for calling all heads. Now you have $5. Had you bet 100%, then the first toss could have made $10 or lost all your money. Now that might be a bet you want to take, but why would you?

Consider that you might do a bit better than 50%, and as long as you do at least 10% you are back where you started. There is a small chance that you could get 0% and lose everything, but that chance is equal to you getting 100%. If $1 was all you had the 0% ($0 left) is a negative of a greater magnitude than a 100% ($10 left) would be a positive. That sentence was confusing, but it means that the extreme negative event is more bad than the extreme positive event would be good. Getting shot once is far more to cry about than not getting shot 10 times is to cheer about.

This lengthy example was a type of diversity. It is true that it is only one game and you can just have equal bets, but the number of the bets is a type of diversity. You spread the risk of loss over numerous chances giving yourself a strong chance of coming out ahead even with some losses. No one can predict anything precisely so you need to position yourself to reap as much reward and evade as much loss. You can’t find rules this beneficial in the real world. At least you can’t be sure. There might be a mix of stocks that can give you something resembling a return like this, but you can’t ever know that. The odds and payouts are not set out for you in such a structured and consistent way.

None of that was particularly common per the section title, but let me fit it to the mold. If you spread your investment portfolio over numerous stocks and sectors you reduce the risk, while keeping the hope of solid returns alive. Asset allocation is the most common diversity model (broadly there are different allocations designed for specific goals). Asset allocation is well covered all over the place, I just feel that the discussion of techniques that apply within the asset classes is not covered. It is technically covered in stock analysis in general, but I want to tie it to the theory of diversity. The common approach to diversity would mean playing more than the quarters game, while I want to focus on the individual components, i.e. individual bets. Not groundbreaking, but important. It has been a while since I’ve written anything and I am easing back in with a simple enough topic, which I endeavor to make more complex.

The true goal of writing about something that you will understand if you read 10 other articles is to actually refine your knowledge after you read those 10 articles. I know you would think that the goal would be to not have to read those other 10 articles, but you’re better off reading them and this one. I would never presume to replace other articles, because I learn best when I learn from numerous sources. It allows me to impart my own brains to the synthesis and come up with something better. To use a map metaphor, I like to know all the roads and then decide which one is best rather than being told the best road. This is partly because people and GPS devices can be wrong, with the former usually being wrong. The other reason is that conditions change and I should be able to move with those changes.

Spread the Risk like Butter, Hope for Delicious Toast

Take a lesson from the venture capital industry. Instead of aiming for the bulls-eye do your research and give yourself the best chances. It would be great if you could set your self up for a few major gains even if the majority of your choices don’t pan out. One Apple in 1999 can wipe out a lot of losses in a portfolio and can even make gains. You should not overly divide your portfolio and really to implement any sort of real diversity I would start with at least $25,000, but a lot of the best diversity techniques probably won’t kick in until the $50k-$100k range. You want to get the point where using minimum $5k positions is not a massive exposure.

I am going to introduce you to the brainstorming portion of the article. Have you ever found that reading about other people’s “systems” is not particularly useful? I mean some are actually applicable, but this one is not one of them. It is just to give some example of diversity in practice, and to throw out ideas that might be incorporated. So that is what I want to do.

Diversity is more about lessening risk though, but the concept still applies. Basically imagine that you wanted 10% of your portfolio in banking stocks. The thing about me is that I do not like having 6 different banks because that is what mutual funds are for. So now I am chipping away at excess diversity. I would find my top 2 choices and probably go for 7% as my winner and 3% as my secondary. This divides the $5k position between 2 stock. In this case, I would look for a high risk and high reward stock as the smaller stake. That way you add a little spice to your investment. Even my primary position would not be all widows and orphans. The point is to give yourself some safety while allowing yourself to capture the big movers. Banks aren’t the best example, but technology has a lot of gems. There are safe tech stocks and risky ones. You should have a couple of the safe ones, but have a couple of ones with serious potential. Ones with the best potential also have the potential to scare you to death.

Too much diversity can be a bad thing. That is why using ETFs and mutual funds can be a sloppy way to achieve diversity. They have their place, but you should structure some of your money in a multitude of potentially high return investments. The diversity in the risky assets can maximize the potential for gains, especially if you’re good at research. The only problem is systematic risk, because you really can’t protect against that. You could try a mix of long and short, but that still carries quite a bit of risk. Prior to the crash stocks were doing well so when do you short? At the bottom. I am not a huge fan of shorting, mostly because I can’t see myself ever doing it effectively. I prefer to capture downside by buying puts, which is also a great way to protect your major investments. It costs a bit, but it might be worth it when you get edgy. If you are already up substantially it might be worth it, but if the stock pays no dividend and stays flat for too long you’re better off selling than just buying puts over and over. Those are topics for another day.

Just remember that if you pepper your high risk investments throughout your portfolio you can increase the diversity within asset classes. Along with an allocation mindset you can increase the overall diversity of your portfolio. This can allow you to undertake more risk and try to capture higher returns. The goal is to spread the rate of failure so that the most likely consequence is to come out ahead. In the coin toss game above you’d be ahead with a win ratio greater than 1 out of 10. We all wish we could have that, but even getting out even at 50% would work out well enough. Mix that with some standard safe investing plus some income, and you’d be fine. The secret to success is giving yourself the highest probability of coming out ahead, and that is usually by taking part in a lot of smaller probability contests. We tend not to think in terms of probabilities. You want loss to be on the small end of the probability spectrum, but you’ll never eliminate it. There will always be a chance that even the most diversified portfolio succumbs to a zombie apocalypse.

TLDR and Conclusion

Diversity is not just a way of managing risk, it is a way of giving yourself permission to invest in riskier things as long as you give yourself the best chance of coming out ahead. In order to do this it isn’t the best choice to differ the risk across asset categories. Instead you should diversify the risk within the category by mixing safer stocks with riskier ones. If you do your research well and choose the right stocks you won’t need the really boring ones, because the probability of you coming out ahead will be greater. Imagine a 30% chance of loss with subsets of greater and lesser loss. A 20% chance of being basically even, and a 50% chance of coming out ahead with subsets of greater gains. Risk will always exist. You can cut potential returns off at the knees and go for very safe investments, or you can go with riskier investments with greater returns but between the lot the chance of success is higher. It is just like playing multiple hands of blackjack simultaneously instead of using your whole bet on one hand.

 

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