How Many Investment Eggs in One Basket?
Diversify, But Not Too Much
Grant S. Donaldson
Most big fortunes have been made with big bets on successful businesses…Most fortunes in the United States have been made with hugely successful businesses – driven by entrepreneurs that sink all their resources into a single enterprise and then grow it through grit and savvy and customer demand. Think of any large company and behind each one was a passionate dreamer who sunk their energies and finances into a single successful company. Classic historical success stories, for example: Coca Cola, Ford, Hersheys, Microsoft.
Concentrated Wealth Cuts Both WaysOf course, if we focus exclusively on the tiny fraction of colossal success stories, we are ignoring the huge number of businesses that fail within several years of founding or only grow to a small level of success. These smaller businesses constitute a much larger proportion of business history…a very large proportion. According to the Bureau of Labor Statistics, only one third of businesses celebrate their tenth anniversary, and even at that milestone, only a tiny proportion generate more than $100 million in revenue. While some entrepreneurs take everything they have, financially and otherwise, to invest in a single entity, we know that this is clearly a dangerous endeavor given the inherent challenges, competitive factors and ongoing risks of capitalism. Over time, most businesses fail, fade away or grow to only a fraction of the biggest enterprises.
Another Way to Build WealthMany choose not to take on the risks of company-building, and yet want to participate in the wealth-building benefits of growing institutions. This, of course, can be done through stock ownership. Public stocks represent underlying companies that have overcome extraordinary hurdles to become huge entities. And often these huge entities continue to grow despite their size.
No Guarantees of Continued SuccessJust because a company has reached significant size does not guarantee continued success. Capitalism is disruptive: poor management, new technologies, and new industries are factors nipping at the heels of all businesses. Many well-established publicly traded companies have been disrupted out of business. Of course, their stocks have imploded in the process.
All Eggs in One BasketInvestors can see from this and by researching history that, over time, businesses can hiccup, and concentrating investment wealth in one entity or industry is inherently risky. But unlike entrepreneurs who infuse everything into one all-consuming entity, investors in public stocks can easily allocate their capital across many business enterprises. This is diversification: the process of allocating investment capital across more than one security to reduce single stock/single company risk. Investors that purchase individual securities need to decide how much individual stock diversity is ideal. For example, a clear danger exists when employees load up on their employer’s stock through stock purchase programs. Over time, their ownership often constitutes a large proportion of their net worth. Is it ideal to have net worth and salary – essentially one’s entire financial welfare – tied up in one company? Schwab says no more than 20% of investment assets in one’s employer stock. Some financial planners say less – maybe 5-10%. The Employee Benefit Research Institute says that employees have gotten the message. Most employees with employer stock purchase plans have kept their levels down to 8% in the recent decade. (1)
What Do We Recommend?So what do investment studies say? Many studies suggest that if you are working with individual securities vs mutual funds or ETF’s, individual stock risk is reduced substantially when you reach 20-30 individual securities representing various industries.(2) The incremental benefit of adding more positions beyond that level for single stock/single company diversification is minimal. While stock market risk continues to exist, single company risk plummets. In history, we have found that exclusively purchasing high quality companies at good valuations while concentrating portfolios in 25-30 positions can provide lower than market risk and generate good returns over time. Screening for and consistently evaluating company financial strength, longevity and effective competitive stature can differentiate concentrated portfolios from current era commonly practiced index investing strategies. Concentrated stock positions allow for probability of outperformance relative to broadly diversified stock indexes because they are focused and different. (3) The financial/investment industry has, in fact, migrated to policies that extol the value of wide diversification to a level that might be interpreted as overkill…allocating to indexes that hold 1,000’s of positions in a varied mix of different asset classes. These allocations are so widely diversified that they ultimately produce vegetable soup returns over time and make it difficult to have outsized performance.
A Wide Spectrum of Diversification ChoicesSomewhere along the continuum of diversification choices – from massive resource allocations into a single company, to excessive allocation across all asset classes and 1,000’s of securities – there lies a sweet spot for 1. Ideal diversification and 2. Excellent long-term returns. Both goals can be met with a concentrated blend of high-quality stocks. Please visit: https://tudorfinancial.com or www.tudorinvest.com
Grant S. Donaldson, MS, CPA
Tudor Financial, Inc.
Grant Donaldson has contributed to the accounting, tax and financial professions for over thirty years. He established Tudor Financial, Inc. in 1992 and continues to serve individuals, families and institutions with his experience in asset management, tax analysis, estate planning, and other financial planning needs. He is a prolific writer and researcher of investment history, strategy and risk management methodologies. He has provided hundreds of presentations to groups throughout many years of service in the financial profession. Tudor Financial, Inc. currently serves a record number of clients and provides management for a record level of client assets.
(2) Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets, Vitaly Alexeev, FIRN Research Paper, November 2012
(3) Information available upon request