Diversification.
The only “free lunch” for investors, according to some.
A tool for the uninformed, according to others.
I’m not here to argue it either way – I’m personally in the camp of the former – because I’ve already made my mind up and invest accordingly.
What other people decide to do is up to them.
Everyone has their own risk tolerance and views on diversification.
People should always invest as they see fit.
So I’m not writing this article in order to in any way convince anyone of any level of diversification, nor will I be delving into the historical numbers that prove out why diversification is so important and worthwhile. I’ve already put together content like that over the years, so I don’t want to retread old ground.
I’m instead putting this piece together to have a conversation on some of the rationale behind the broad diversification of my own portfolio.
Specifically, I want to speak on a concept that detractors of diversification sometimes point to.
Diworsification
That concept is “diworsification”.
A term popularized by the great Peter Lynch, it’s a play on the word diversification that refers to diversifying to the point of worsening your portfolio.
An example would be to go after low-quality/high-risk investments simply to diversify.
One shouldn’t ever diversify purely for the sake of diversification.
Obtaining a new investment that reduces the risk/return ratio of your portfolio is diworsification.
Sometimes this is only seen in hindsight, but it should always be avoided when it’s clearly present.
I actually read about some so-called dividend growth investors jumping on the Bitcoin craze a while back. That would be, in my view, a prime example of diworsification. Throw in a great deal of speculation on top of it.
Diversification
Diversification should be used to spread and reduce risk. That’s it. It’s risk management. Used appropriately, it can allow you to get maximum return at minimal risk.
Of course, what’s “appropriate” will vary according to one’s own risk tolerance.
There are few successful investors who have either argued against diversification or have invested in a heavily concentrated manner over a very long period of time.
Even Peter Lynch (one of the greatest stock investors of all time) managed over 1,000 positions in the Magellan Fund toward the end of his run with Fidelity. So he clearly saw the benefits of diversification, but he also strongly diversified in a way that didn’t outwardly worsen his portfolio or performance. (Do as I say, not as I do.)
Diversification is important because significant concentration carries a lot of risk. One unforeseen event could wipe you out if you’re too concentrated. It could at least severely affect your wealth, income, and overall outcome in life.
Diversification might be the only “free lunch” out there because it offers significant benefits without significant benefits. It has a very favorable risk/reward relationship when used intelligently.
As Peter Lynch obviously saw and experienced firsthand, there are a lot more than just a few extremely high-quality businesses in the world. As such, there’s absolutely no need to concentrate too strongly into just a handful of companies.
Indeed, as I’ve noted before, one of the main benefits of investing in the S&P 500 is the broad diversification it offers. You’re investing across ~500 companies. Not all businesses are created equal. Not all of them are fantastic. But there’s surely more than just ten out of the 500 that are doing very well at any given time. And when some businesses aren’t doing well, others probably will be performing better. That’s just the way the economy generally works. Not everything is humming in sync at all times.
My Diversification
With all that said, I think diworsification is a terrible idea.
Just like there’s no need to strongly concentrate oneself, there’s also no need to diworsify oneself.
My FIRE Fund is spread out across 115 world-class businesses.
Every single company in the Fund is paying me dividends. And the vast majority have lengthy track records of routinely increasing their dividends year in and year out. That’s because these companies are adept at increasing their profit over long periods of time.
I’m broadly diversified across business models, industries, geography, etc.
I’m also set to collect almost $13,500 in dividends over the next 12 months.
If one, two, or even three of these companies were to cut or eliminate their dividends, however, I’d be okay. My lifestyle would carry on as it does. Dividends are, after all, almost always “in the green”.
The dividend increases from the remaining 110+ companies would quickly make up for the lost income from the cuts or eliminations.
Knowing that I’m going to be okay even if a world-class business or two runs into severe problems helps me sleep well at night. I sleep like a baby.
And since I don’t see my level of diversification (which trails the S&P 500) as anything close to worsening my portfolio, it’s a no-brainer.
Concentrating into just 20 or 30 stocks (or less), though, would have me sleeping a lot less soundly.
In that case, a few adverse dividend changes could potentially create some lifestyle challenges. Especially if the same 2-3 stocks were in both samples (which is certainly possible). Since it’s not less expensive or less difficult to construct my portfolio in this way, there’s no reason to do it.
My Definition Of Diworsification
I’ll tell you how I personally define “diworsification”.
This is coming from the perspective of someone who’s been a dividend growth investor for almost a decade now. I’ve successfully invested my way into FIRE at just 33 years old, so I’d say it’s worked out great.
I’m going to define this term within the universe of dividend growth investing (ignoring the aforementioned likes of Bitcoin). I’m talking purely stocks here.
I get emails all the time about the portfolio. One email might go along the lines of asking me why I don’t yet own Stock X, Y, or Z. The very next email will ask me why I own so many stocks. It’s actually quite amusing.
Nonetheless, I hope this article will serve to better clarify my stance on all of this.
I mentally separate diversification and diworsification through one simple question before taking on any new investment:
“Would I be comfortable owning this entire business?”
That’s it.
If I wouldn’t be happy with owning the entirety of the business, if I absolutely had to, I shouldn’t be happy owning even just one share.
I can tell you that I would be comfortable with only owning the entirety of any one single business in my portfolio – if I absolutely had to.
But since I don’t have to, I don’t see any reason to invest like that.
I remember investing in The Coca-Cola Co. (KO) way back in 2010.
I felt so happy acquiring shares in the world’s largest non-alcoholic beverage company. When someone bought a can of Coca-Cola or a bottle of Dasani water, I was earning a small portion of money from that transaction. Still gives me warm and fuzzy feelings to this day.
If you would have told me I had to own only shares in Coca-Cola, I wouldn’t have been uncomfortable with that idea. But I don’t have to. And there’s no reason to invest that way.
Likewise, I remember acquiring shares in PepsiCo, Inc. (PEP) shortly thereafter.
I felt extremely happy about this purchase, too. It was a beverage giant in its own right. But I was more excited about the snacks business, which they’ve been dominating for a very long time now. When people are munching on Doritos, I’m cashing dividend checks. A nice calorie-free snack for me!
If you would have told me I had to only own stock in PepsiCo, I could do that. Again, though, I don’t have to. And there’s no reason to be that concentrated.
This line of thought scales way up. That’s because there are hundreds of high-quality dividend growth stocks out there. To force oneself to ride it out with a few is, in my opinion, nonsensical. It’s taking on unnecessary risk for no apparent reward.
Conclusion
It’s up to each individual to find the appropriate amount of diversification across their investments. That’s a personal choice.
Of course, diworsification should always be avoided.
If I wouldn’t be happy theoretically owning the entirety of a particular business, then buying a single share of that business would be diworsification to me.
I’ve found that the question proposed earlier has helped me avoid diworsification, while simultaneously building a broadly diversified collection of some of the best businesses in the world.
“Would I be comfortable owning this entire business?”
And I believe that asking myself this question before any investment will continue to aid me in the future as I go about acquiring shares in businesses I don’t yet own a slice of.
Full disclosure: I’m long all aforementioned stocks.
What do you think? Is this a good question to ask oneself to avoid diworsification?
Thanks for reading.
Image courtesy of: Stuart Miles at FreeDigitalPhotos.net.
P.S. If you’re interested in building a diversified portfolio on your way to becoming financially independent, check out some amazing tools and services I’ve personally used on my way to becoming financially free at 33!
Jason,
Great post. I agree with you, and am sitting at 60 positions right now (soon to be more!). I’ve been asked a few times before how I track stuff and I answer its pretty easy for the same reason you did on Twitter – also if I need an update I can use this great thing called the internet with sources like Morningstar, Seeking Alpha, etc. Heck even my broker tracks stuff for me straight up. Easy peasy.
– Gremlin
Gremlin,
Yeah, I totally agree. I’ve always been mystified by the idea that having a large portfolio requires a bunch of work. It’s not like people are running themselves ragged owning the S&P 500, even though they technically own 500 individual stocks.
Regardless of one’s diversification level, though, the real point here is that you shouldn’t diversify just to diversify. If you have some kind of “shiny object syndrome” going on where you just want more stocks, you’re probably going to end up diworsifying the portfolio. But one can stick to just high-quality dividend growth stocks and still end up with a portfolio of hundreds of stocks. Both events can happen simultaneously.
Cheers!
Hi Jason. Having a diverse portfolio is the key with out question. I ” retired ” back in 04-05 before the financial crisis of 08-09 and really had little impact from that whole mess. I dont have any were near 100 companies but still did fine 😀 I will be 58 this year and got back into adding positions last year for fun.
On the other hand I remember holding 72,350 shares of EMC stock options when the company was over $100 a share, my cost 6 cents a share ( you can do the math ) EMC quickly fell tp $3.00 a share and never really recovered and is now owned by Dell
Hard lesson learned but I was diversified even back then and was still able to retire early.
FIRE was pretty much unknown back then but through the years the pioneer’s of current day FIRE pretty much set the frame work of all of us to follow JD Rockefeller among others were early FIRE pioneer’s.
I enjoy your site. Thank you for all you do.
Bob,
Sorry to hear about what happened with EMC. Sounds like you still did quite well, though! Concentration can be fun if/when things are zooming along, but it can be crushing if things don’t go your way. Even if you do your due diligence and you approach an investment highly intelligently, anything can happen. Even great companies can misfire severely. Taking on unnecessary risk (via heavy concentration) seems dumb to me, but to each their own.
I find it interesting that Lynch, who coined this term in the first place, was widely diversified. I think people have taken the term to mean that one should heavily concentrate, but that’s not actually what the idea stands for. It just means you shouldn’t buy garbage simply for the sake of having something new/different.
Thanks for dropping by!
Best regards.
Hi Jason,
I notice that we have lot of free info and blogs about Warren Buffett on the internet, but not many as well for Peter Lynch, who get nearly 30% return on investments from 1977 to 1990. He is not so famous.
I would like to know more about him, which stocks he did buy and his strategy, is there any history of his past holdings and portfolios?
Enjoy your Vietnam trip, thank you.
praya,
Hmm. There’s quite a bit of information about him. Just not quite as much as Buffett. I think that comes down to the fact that he was more private and essentially retired from professional money management almost 20 years ago (before the Internet took off).
He wrote multiple books, the most famous of which is probably “One Up On Wall Street”. Check them out!
Cheers.
There really is more than one way to achieve the results you are looking for, and you have to look no further than three of the greatest investors of our life time to prove that. As you say Peter Lynch believed in hand picking over 1000 stocks for his fund, the recently deceased Jack Bogle was a believer in owning the whole market, not trying to beat it ( his phrase was don’t look for a needle in a haystack, own the haystack), and Warren Buffet famously was quoted as saying ” diversification is protection against ignorance. It makes little sense if you know what you are doing” All three had brilliant investing minds and very successful, but three different ways to approach it. It is ironic though that Buffet, in his will wants 90% of the money left to his state put in the Vanguard S&P 500 index, with 10% in Vanguard Bond Fund. Is he actually saying his spouse and probably most people, don’t know what they are doing, so better to buy the market? Interesting.
Brian,
Right. As I noted in the article, I don’t know of too many successful long-term investors who did really well with, or personally advocated, being extremely concentrated. Buffett hasn’t been concentrated in a very long time now. Neither was Lynch or (obviously) Bogle. Schloss is another example of being pretty widely diversified, even though he was really more of a “stock picker”. Munger might be the best example I can think of in terms of someone who would generally be pretty concentrated. I remember looking into the way he manages Daily Journal a while back, and it was concentrated.
Still, though, there are few arguments for it, and many against being heavily concentrated.
I look at my own situation now. Suddenly condensing from 115 positions to 20 or something would not put me in any better shape in any way, yet it would definitely dent my quality of life (in terms of thinking/worrying about my portfolio). It comes down to the Buffett quote about how it’s dumb to risk something you have for something you don’t need. I’d be risking FIRE (something I have) for something I don’t need (potentially more money via the chance of outperformance). It’s silly.
Either way, though, the article isn’t really about diversification. It’s about diworsification. And I think the question I posed succinctly defines it. 🙂
Best regards!
I think it comes down to what kind of portfolio are you comfortable with, that will allow you to sleep at night, and not bite your nails at during the day.
I once had my entire net worth in my ex-employer’s stock in my 20s, 100,000 shares at 15 dollars. Over the years, the stock has split 12:1, increasing those initial 100,000 shares to 1,200,000. The stock price hit 300 last year. Over these 20 years I’d diversified out by 99%, but the remaining shares still make up a large percent of my portfolio. There are many many stocks, particularly in the tech sector, where it would have paid off huge to not diversify. But I concede that it’s like gambling. I’m intimately familiar with my ex-employer’s strategy but could never have predicted their actual trajectory and where they ended up.
Ty,
Yeah, that’s a huge gamble. It’s like going all-in on anything else. It’s great when it works out, but it’s a disaster when it doesn’t. If the goal is FIRE, though, it’s nonsensical to concentrate so heavily, because you’re essentially risking what you need (freedom) for something you don’t need (the possibility, albeit unlikely, of superfluous wealth). A few DGI guys out there were heavy into Kinder Morgan a while back, which obviously didn’t work out and surely could have negatively affected one’s FIRE if they were relying heavily on that income. You just never know if/when a company, even a high-quality one, might have major troubles. There’s no reason in the world to bet heavily on it either way.
Regardless, the article isn’t really about diversification, although it seems like that’s how some people are reading it. It’s really more about the concept of diworsification, which speaks on why I haven’t felt uncomfortable owning a large number of wonderful businesses. 🙂
Cheers!
Hi Jason,
First time commenter.
I am a long time reader from back in your DM days. You inspired me to clarify my own path to FIRE, arriving 5 years ahead of schedule. Your well thought out and well articulated stock choices helped me develop my own approach here in Canada. And I now I am enjoying your post FIRE journey and developing mine as well. As it happens I am in Chiang Mai until January 27 and back again February 14 to the end of the month. My travel companion and I would like to treat you and your lady to lunch at your favourite spot if you are available. Just want to say thanks for all that you do.Please connect privately .
Cheers, Barb
Barb,
Thanks for the support. Glad you’ve enjoyed the content over the years and found it inspirational. 🙂
Congrats on getting to FIRE so early. That’s fantastic stuff!!
Shoot me a message via the contact form and we’ll see if we can grab lunch. I eat lunch at a very casual Thai market most days (unless it’s closed).
Best wishes!
Hi Jason,
I own 81 positions yet and there are also some not successful positions in the portfolio, but they are the minority. I think there is a difference if you want to buy everything, even when the chances of success are very low. On the other side you will have for some reasons companies which are getting worse when you own them OK, Kinder Morgan was a star not too long ago and I still own 100 shares from this company. Its far away from the past with over 50 cents dividend/quarter, but I don´t see this company hopeless. On the other side some companies are turning around. One good example for this is BHP Billiton, which paid great dividends last year after a very unlucky2017. Now a special dividend in January and I think a quite good dividend in March. But to live which such fluctuations it is necessary to have many positions to stabilize the portfolio.
My worst shares at the moment are General Electriv, Owens & Minor and Coty. For GE I think it will change, but it will takes it time. Owens & Minor or Coty are a bit different and may be they will fail. So I can sell them (I was thinking of it from time to time) or do nothing, what is what I will do for 80%. So you have also a development for worification in your portfolio. Thats investing and it will always happen. But buying risky shares is at the most of the time not a good idea. OK, you can go as well a strategy to buy for small amounts of 500 $ 5 – 10 different new hopeful companies. And if one is ending good you can compensate the rest. But this is gambling and sometimes you have luck and most of the time it doesn´t work out. If I buy instead for that money 1 – 2 good successful stable companies with a reasonable price I will get most of the time more success. To buy a today brandnew Amazon, Google, Microsoft or Apple is a lot of luck and I´m sure that there are 1 – 5 small companies outside today which will do the same in the next 20 years, it is impossible to know which companies that are.
Lets take for example Tesla. This is a company where everything can happen. You can lose everything if the financial issues get critical or they are not able to produce enough cars to make the business stable. On the other side if they can do that and make brand new cars and other products you will gain a lot of money. But nobody knows and you see it all the time the uncertaincy on the fluctuation of the share price. OK, this is not a share for dividend investors, but there are a lot of people outside, owning some shares of Tesla and hoping that everything will work out. Same as Apple if they get successful they will start sending dividends to the share holders and may be in 10 years its a company for dividend investors. I do not own shares from Tesla, its too risky for me and I prefer more stable companies. On the other side I own shares from Facebook and Alphabet, even if they don´t pay dividends. But both companies are earning a ton of money and I´m sure both will pay at some day a dividend. Tesla could be worsification, but this must not be the case. Facebook and Alphabet can be worsification in the future as well, but the chances are not too high.
I don´t know with how many different positions I will end up in the future. I don´t think of it. I see, the more positions I have the more I like to upgrade existing positions like I did in the past with Apple, UPS, AT&T, Skyworks Solutions, Starwood Property Trust, AbbVie or Altria. OK, sometimes I buy a new company like my last one with Dominion Energy. But these are all no worse companies and if you are chosing such companies you normally don´t get wrong, if you have enough different from them .
Regards Oliver
Oliver,
I hear you. I also don’t know where I’ll end up in the future, nor do I really think about it.
As long as I don’t diworsify myself by going after something new just for the sake of more, I think I’ll be OK. I try to ask myself the question with every new position. A recent example is Broadcom. I wouldn’t want to go all-in on it, nor is that necessary. But I wouldn’t be unhappy if I were somehow forced to own the entire business. I’d be comfortable with that idea, if I had to ride it out like that. However, I wouldn’t be comfortable at all with Tesla (your example above). So it’s just an individual call here, but I think the question proposed in the article serves to separate diversification from diworsification at the individual level.
Best regards.
So if someone asks, “Would you like Coke or Pepsi?”, you say “yes!”
DL,
Yes! 🙂
Cheers.
I’m a lot earlier in the FIRE journey than you, and it’s entirely possible that as my net worth grows my tolerance for concentration will decrease, but as of now, I own in the range of 10-20 stocks with about half of my net worth in my top 6 or so. It hasn’t been so much of a specific desire to be concentrated as it’s been a consequence of my own circle of competence, economic moats that I can identify, and valuations. Frankly, I don’t think I know enough about 100 or even 50 companies, at least not yet, to be comfortable owning them, and I’ve found that even companies I do think I have the ability to understand often either don’t have an economic moat that I can identify or aren’t priced with a sufficient margin of safety for my comfort level. The market isn’t efficient, but it’s pretty damn close. That’s been my experience so far. I figure my number will go up over time as I add more companies to the portfolio as their prices come into a good buy range, but so far, I’ve found that good bargains in the market are pretty hard to come by, and good bargains for companies that are both in my circle of competence and that have an economic moat that I can easily identify are that much more rare, so it has seemed prudent to back up the truck and load up when I have been able to find them, within reason of course.
Austin,
Hey, whatever works for you. I’ve found that there are a lot more than 10 or 20 wonderful businesses out there. Even with the 115 I’ve got, I can immediately think of 20+ amazing companies that I don’t yet own. As long as you can sleep well at night and afford to take a loss/dividend cut on a company or two (because anything can happen), go for it. I’ve surrounded myself with winners, so I sleep like a total baby. 🙂
Cheers.