One of the first principles a new investor stumbles upon is “don’t put all eggs in one basket”. In other words, diversification is said to be the key to investment success. My longer time readers know that I am strictly opposing this approach in its extreme form. The viewing angle might be even the right one – winning by not losing, respectively by minimizing risks – which is also my strategy. However, there’s a material difference between buying blindly a big basket and focussing on a few investments where one has done the homework.

Summary and key takeaways from today’s Weekly
– Discussing focus-investing and diversification is a topic of heart for me.
– Many things depend on the point of view. Be careful with certain marketing messages without questioning them further.
– A plea for a focussed portfolio.

Who hasn’t heard of the ultimate tip for investing success?

–

Don’t be an idiot, diversify!

The one universal rule even idiots in finance know is diversification. You gotta diversify.

The more diversification you can get, the better.

Single stocks are a bad place to invest. It is better to spread out.

Diversify, diversify, diversify!

–

And so on and so on.

These are just a handful of examples novice investors are brainwashed with.

I am getting straight to the point here in a provocative way without too much bla bla, because I am tired of this campaign which when thought about in-depth, does not make much sense – if investors seriously want to make a few bucks with stocks.

I see some urgent need for an explanation.

In life in general and in investing in particular, there tends to be a lot of black-and-white thinking. Interpreting information or worse just pieces of information in their short form and in their extremes only rather causes misunderstandings and confusion instead of being a helping hand.

Without further ado, let’s dive into the topic whether stock picking or focus-investing as it can also be called indeed is really super risky like it is portrayed. I’ll also answer the question why ultra-broad diversification is not the holy grail it is advertised to be.

The average total return of all my stock ideas is still slightly trailing the S&P500 and the Dow Jones. However, the gap has become narrower as especially my latest “Trump Trade” has more than doubled in less than six weeks. I expect more to come.

This serves as a good example for today’s Weekly.

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^{both as per 27 March 2024 market close – since August 2022}

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Focus-investing – risky or not?

The short answer is, it clearly depends on the perspective one has. Is the glass half-full or half-empty? Factually the same, but not practically.

In German, we would say “ein klares Jein” (a clear “yes-no”).

You can’t just give a straight answer right away that’s precisely correct without any alternative, because indeed it depends.

The common narratives regarding stock investing are:

• diversification is key to spread the risks
• high concentration increases risks due to higher weightings of individual stocks which can draw down a portfolio massively

I am pretty sure everyone has heard of them.

The evil thing about these phrases is that they are not wrong when just taken at face value. You can’t just say “no, that’s not true”. Inherently, they are true.

This is likely why so many people believe in them without asking further questions.

Don’t get me wrong, Warren Buffett said it numerous times and I am seeing it similarly: Investors who either have no time for own research, not enough confidence to analyze a business or as the worst option no clue of what they are doing – or all in combination which can also occur – then it is definitely better to invest in index funds instead of letting inflation eat your purchasing power away over time. I agree on that.

A few years ago I would have added “slowly”, but this does not really fit anymore. A look on grocery and energy bills tells a different story.

Index funds as everyone knows offer a broadly diversified investment while achieving over the long-term average market returns in the ballpark of 7–10% gross before taxes. At least these are the historical numbers. They include crashes and corrections as well as dividends.

I fully agree that something has to be done (investing) and that risks should be kept as low as possible in order not to lose money in the worst case even on a nominal basis.

“Winning by not losing” is an approach I am sharing and agreeing to. Definitely.

However, these mindset frames fall short on several fronts.

Those willing to do some own due diligence, but seeking inspirational ideas, understand that services like mine are there for a reason.

First of all, I like to ask the question who really benefits from index investing? The naive investor or rather all sorts of funds, being it actively or passively managed, whether picking individual stocks or replicating indices or sectors?

I tend to point at the latter who collect their fees regardless of what the market does.

Of course, in good times the cashbox rings louder. But even in the case of a bad performance, fees are charged. The incentive to stay in such vehicles and to focus “on the long-term”, no matter the performance, first and foremost keeps people invested and avoids money being pulled out of funds. Perseverance slogans as I like to say.

That’s the cold, hard truth.

Taken in its shortened form, it is likely a bit extreme, but in the same way like the pro-diversification phrases from the beginning of this chapter, this is not inherently wrong.

Yes, but …

You see, it depends on the viewing angle.

For those replying with “costs are negligible nowadays”: no they are not. These providers make their money not on quality, but on quantity, like discounters. And they eat into your performance still. Not much in the short-term, but considerably in the long run.

What one should also be aware of is that “market average” doesn’t mean there cannot be any hard years with massive drawdowns. While many know that theoretically, having a strong stomach when one is stress-tested is an entirely different story. Many of today’s pundits have never experienced a real multi-year long bear market.

+30% in a year make you feel great. If the entire market is down by 30%, I am not sure many will easily sail through. A gain of between 7–10% p.a. on average still has massive swings. This will be important a few paragraphs later.

Here’s another one.

They pitch their target group with average market returns as a positive. What they don’t tell is that this is also automatically the ceiling – there cannot be more than that. Would they still be highly convinced and highly on fire for index funds when the sales pitch were “we offer you a capped maximum return of 7–10% p.a. while we expose you to the full downside of the market”?

Reads completely different, doesn’t it?

By the way, after costs, not even that.

Beating the market when investing like the market is not possible.

Taken at its extreme, this means that one is investing in index funds with limited upside, but unlimited downside – thank you very much! Of course this is a too blackish view as the downside is also limited. But major drawdowns – which I referred to with by saying “unlimited downside” – clearly are not excluded.

What I wanted to stress with these examples is that one should think a few things through when being confronted with such advice. Always ask the question who benefits and what are the pros and cons. One needs a strong stomach because even highly diversified portfolios can fluctuate much. They can achieve no performance for many years, either, especially when bought at a historical top. One has to know that.

One or the other of my longer-time readers will remember this slide from my webinar I once held.

Enough bashing of fund and index investing.

My main topic is the question of whether focus-investing or stock picking with seemingly low diversification is super risky.

It depends on the definition and the viewpoint.

For the more sophisticated investor aiming for higher returns, but also for the more risk-averse investor, stock picking is the go-to tool. In the case of the latter, it is a good way to circumvent overvalued and overcrowded sectors and stocks.

Also one can argument that by achieving higher returns in good times, there’s a higher buffer for tougher times – assuming one sells one or the other overvalued position in time.

What many forget is that valuation is clearly a risk factor, no matter how good the underlying business is doing.

Just take a look at Cisco (ISIN: US17275R1023, Ticker: CSCO). It was practically for the internet what Nvidia (ISIN: US67066G1040, Ticker: NVDA) is today in terms of graphic chips. Leading the pack of a new trend with a growing business.

This does not have to result in investing success – even in the long-term. Despite the company being much bigger today with more sales, earnings and cash flows.

Valuations do matter! You will hear that from me often, promised!

If you want to say that no one is so stupid to catch exactly the high: yes, there are enough people who do exactly that. Not by the exact day, but 10% higher or lower does not matter if you have a drought period like the following.

The main problem is that risk is commonly associated with and defined by how much a stock or portfolio fluctuates, especially thanks to academia. In other words, the volatility – how much up and especially down it can go – is seen as a synonym for risk.

Professional investors can only laugh when they hear that.

Extremely spread investors typically don’t do much fundamental analysis and they don’t see themselves as co-business owners. In the extreme, they even don’t know where they are invested in and how their portfolio holdings are weighted.

This comes close to ignorance – something Buffett and Charlie Munger have warned of. Namely, in the context of diversification being a shield against ignorance.

Not knowing what one is doing is what is dangerous.

Remember what I wrote above about drawdowns with index funds?

If volatility were the perfect yardstick for risk, index funds should be clearly risky, too. In a year like 2022, most markets and sectors tanked due to inflationary pressures. If one was overweight tech – this was a really tough period, despite the succeeding gains back up. Many of the big techs lost more than 30%, some even 50% in just a few months.

I am purposefully writing most markets, because energy or agricultural investors have done great during 2022. It depends on how one is positioned.

Risk shouldn’t be understood as volatility.

That’s ignorant. Risk is being clueless about the own investments, because that’s where the negative surprises can come from. If paired with a high concentration and high valuation, this can end really badly.

But if high focus comes along risk management and knowing what one is doing – is this a guarantee to do great? No, it is not. There are no guarantees in investing. There are only odds and probabilities. But is it focussing really riskier than blindly investing in a supposedly highly diversified basket?

Not so sure, as most indices are not equal-weighted, meaning often a few holdings constitute the majority or at least a big chunk of the entire investment – the opposite of what one wanted to achieve by diversifying broadly. We know that for example the S&P 500 and the NASDAQ are heavily dominated by a few big tech stocks. The top 10 in the S&P 500 e.g. have a weighting of ~35%.

Is this diversification or already focus-investing?

What about “diversifying” ETF holdings by adding the big tech stocks as individual investments? There are people who thinks and act this way.

By the way, in Europe the index concentration is also high – a few big names decide upon the rest so to speak.

For me personally, that’s pretend-diversification and full-throttle high-risk as a fundamental investor.

Just a few bets decide what happens.

Don’t tell me all those micro-wighted 0.2% pieces bring something meaningful to the table. Even if such a company triples, a “diversified” investor won’t notice.

Where does focus end and where does diversification begin?

That’s a hotly debated question. In practice and from what most professional focus-investors say, the border lies somewhere between 10–20 different stocks in a portfolio. Of course, some do fine with less than 10, too. Personally for me, I like to see my entire portfolio on my iPhone screen without having to scroll as a rule of thumb.

The reason is mathematics.

The higher the amount of different stocks, the lesser the diversification effect. It clearly makes a difference whether one is all-in in just one idea or whether there are 10 stocks. But this spreading effect becomes less and less. You’d need to go exponential, however, this cuts massively into the performance by approaching the market structure.

In practice when one has say 20 stocks of more or less equal weight and one pick doubles, that’s akin to a portfolio performance of 5% – already close to what the diversified index promises to deliver. Reach for one or too multi-baggers from time to time and you not only will do well, but they level out what hasn’t worked out so well – assuming there aren’t many total losses.

The opposite of ignorance is knowledge or at least having firm investment theses based upon research one has done preceding an investment.

With this knowledge, which of course will never be perfect into the finest details, an investor gains a better understanding of the business. The more important part is that as a results, the same investor gets a better feeling for risk and reward to assess the odds. Ideally – that’s how I do it – the goal is to find ideas with on average high optionality, i.e. much more upside than downside.

But the important part: not by looking at and thinking in blue-sky scenarios, but by proper risk management, i.e. downside protection.

This is what stock picking and focus-investing is really about: Investing where the odds are in your favor to achieve a market-beating return. One does not even have to have an ultra-high hit-rate – something that’s commonly mistaken. You can have an incredible performance with just 3 / 10.

If you know ten companies well and three of them result in great investments, this is from a risk-perspective much more favorable than being spread-invested into 500 stocks, where you know let’s say 5% of the companies (25 of the 500).

Not knowing about the other 95% deems to be quite an ignorant and risky adventure, doesn’t it? I couldn’t sleep well at night with such an approach. I prefer to know what I own and why so.

To close, you won’t find any really successful investor who grew on a highly diversified portfolio. It’s always focus-investing. Being it stocks or a personal business (where the concentration is even higher, as except Elon Musk no one has ten full-time jobs).

Conclusion

Discussing focus-investing and diversification is a topic of heart for me.

Many things depend on the point of view. Be careful with certain marketing messages without questioning them further.

A plea for a focussed portfolio.

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