Balancing diversification in individual stock picking
Diversification is often top of mind when it comes to investing and generally speaking it becomes more important as your investments grow. While I generally encourage diversification and claim it is good practice I do believe many new investors go overboard in this regard and end up over-diversifying. How can you over-diversify? Well, let us have a look at that.
Starting out
When I started out in 2014 I invested a lump sum into just 2 stocks. That could very well have gone wrong but I actually believe today that it helped me become a better investor. My picks were Novo Nordisk (NOVO B) and Microsoft (MSFT) which fortunately both have done incredibly well and gave me a great start to my investment journey. Even then I still completely relate to the thought process you might go through as a new investor: "I cannot risk going all in on just a few positions - what if I am making a mistake?" and I honestly find this rationale completely valid. However, during this process, I fear some new investors might miss out on some of the most important, yet basic rules of individual stock picking:
The point of picking individual stocks is to beat the market.
Know the businesses you invest in.
Stick with your highest convictions.
Let us try to address these three individually...
The point of picking individual stocks is to beat the market
We start off with an incredibly accurate quote from one of the most successful investors of all time:
…If your goal is not to manage money in such a way as to get a significant better return than the world, then I believe in extreme diversification...
- Warren Buffet
Picking stocks to beat the market is not an easy task. It requires both effort and time and a little luck. The shorter your time frame is the harder it becomes, but even as a long-term investor you really should not bother with investing in individual companies unless you are willing to take on increased risk and workload. The vast majority of people should instead stick to index funds or ETFs. There is lots to be gained in the long term by getting a 7-10% annual return and for the people not interested in the intensity and effort associated with keeping up to date on your investments and research index funds and ETFs really are the best way to go about it.
However, should you decide to venture beyond this strategy, even as a new investor, beating the market should be your number one priority. Not diversification. That is a benefit of index investing you will have to initially have to forgo. Diversification is "a rich man's game" and should to a higher degree be prioritized by those who already made gains and are looking to keep their fortune and play it safer going forward. That does not make it less important, it just makes it apply to fewer people.
Focusing on just a handful of stocks I have managed to beat the market by more than 3x in the past 3 years. Market represented by OMXC - The 25 most traded stocks in Denmark.
Know the businesses you invest in
The single best piece of advice I always give to new investors is this: Invest in what you know. It is a proven strategy and the single biggest reason for my own success in the market. Prior to making my investment in Microsoft in 2014, I had followed the company to some degree for years. As a user, I knew their products well (Windows, Office, Xbox, OneDrive, etc.) but what made difference was that I one day, as an aspiring game developer, took the time to watch the company's developer conference 'Build'. I remember their new CEO stepping out on stage for the first time and addressing every bit of frustration I had had with the company's products under former management and at the same time laying out a clear path for their new strategy going forward. I came to a clear realization: I know how this company works and make its money, I know and use their products every day and now I agree with their management.
Then brand-new Microsoft CEO Satya Nadella delivers his keynote at Build on April 2nd, 2014.
By the end of the developer conference, I had made my second investment ever and Microsoft made up half of my portfolio as I was entirely convinced of their future success. Since then I have continued to follow the company closely and even though I have taken profits a little along the way, I still agree with their overall strategy and plan to hold for many more years. Here, another key point comes into play - it is a lot easier to stay in the loop if you invest in something that interests you or that you spend time on in daily life anyway. Obviously, you should not invest with your feelings, but do so knowing that you will have to spend time following your investments over time - It makes it easier if you enjoy doing so.
Why you should stick with your highest conviction stocks
Another disadvantage in regard to diversification is what is known as over-diversification. That is what happens when adding a position to your portfolio lowers the expected return to a greater degree than the associated reduction in risk. Unfortunately from my own experience, I have seen this trend with new investors more often than not.
We talked about knowing the businesses you invest in - That applies here too. It is much more difficult to understand and keep up with your investments if you own a small piece of 20 different companies than it is if you own just a few. Risking quoting Buffet again this one is important too:
Very few people have gotten rich on their 7th best idea, but a lot of have gotten rich on their best idea.
Warren Buffet
If you already have conviction in your first 6 companies to do well - maybe even less, then why not double down them? If you have done your due diligence, you know where their industries are headed, then why enter a new position? Investing in technology this holds especially true - There is always an exciting new opportunity to jump onto, but oftentimes the winners just keep winning. Microsoft, Alphabet (GOOGL), and Apple (AAPL) were all among the highest valued tech companies 5 years ago - yet have all been better performers in that same time frame than most other stocks in the space. That is not to say this is always the right strategy. I do own 10 stocks in my growth portfolio today, both small and large cap, but for the first many years building my portfolio, I stuck with just these four - Novo Nordisk, Microsoft, Tesla (TSLA), and Amazon (AMZN).
The final thing to take into account is the power of compound growth. I will not go into the topic in detail today, but I think it is worth mentioning in this context. Having one big position doing well for you is much more effective in terms of compound growth than owning several smaller ones. It can be a little hard to explain but unless all your smaller positions do equally well, you will never reach the same levels of compound gains that one big position can do for you. Tesla makes up more than 50% of my portfolio and because of the growth I have seen with this investment, just a few percent upside can make me a lot of money considering the size of my initial investment.
My personal strategy
I want to leave off with the path I have taken personally in this regard. It is not as clear-cut as you might expect from the way I have been describing it in this post. It is hard to do and I also had to learn along the way. I also want to make clear that I am in no way in opposition to diversification I just see a tendency for many investors to go overboard with it.
I own a grand total of 16 stocks today. Much more than I thought I would just a few years ago. 10 of those stocks are in my growth portfolio and that is partly because I suffer from seeing opportunities in too many areas. When I wanted to enter the semiconductor space, I had initially planned to only invest in TSMC (TSM) but the temptation for buying Nvidia (NVDA) as well became too great. TSMC has done well, but Nvidia even better. Though it also means I will be waving goodbye to future compound growth that could have been. It might just be the state of the market right now that so many companies seem attractive to me, but we will see over the long run whether it was a mistake or not. Then came the IPOs... I entered Unity (U) on day 1 as that too is a company I know so well and see tons of future potential in. Coinbase (COIN) went public and again the temptation became too much as I recently became interested in the crypto market. Entering Xiaomi (1810) and Tattooed Chef (TTCF) as well brought me to a total of 10 and that is where I have set my limit. It feels like the breaking point for me: I now spend more time than ever keeping up with my positions and some of them make up such a minuscule part of my portfolio that they are unlikely to make a difference.
Some of my newer positions are so comparably small they are not labelled on the chart. They are in order, Tattooed Chef (1.21%), Xiaomi (1.16%), Unity (0.8%) and Coinbase (0.3%).
I do have high conviction in all ten and that means that I will be working from next year onwards building up these positions rather than looking into new ones. Some might say that 10 individual stocks are still too little - especially given that the majority is in tech. Due to this overlap, I tend to agree. To counter that issue, I have built my dividend portfolio, starting last year, which is ultimately a play of diversification. That portfolio is there to secure the gains that I have made over the years from my growth portfolio and deliver steady growth and a source of passive income for as long as I am alive. But for a new investor 16 stocks are in my opinion too many and for myself, it is also definitely pushing it. So if there is one thing I would like you to take away from reading this post it is the following:
To ensure I can beat the market [1], I have to know and understand the businesses I own [2] and because of that, I have stick only with my highest convictions [3].
Disclaimer: I am not a financial advisor, the opinions expressed in this article are entirely my own – always invest at your own risk.
