Investiv Daily Sunday Edition

[Sunday Edition: Diversification or Accumulation?] By Thomas Moore on October 2, 2016 [bow-tie-businessman-fashion-man]Joel Greenblatt, in my opinion, is one of the greatest value investors of all time. One thing that sets him apart from many other investors is his willingness to concentrate on a handful of deeply undervalued companies rather than diminish his returns through over diversification, or as Warren Buffett once said “[diworsification].” So how many stocks is the right amount to own to be diversified enough, yet not diminish your potential returns? According to Joel Greenblatt’s book You Can Be A Stock Market Genius, the risk-reduction benefits of adding more stocks to your portfolio significantly decreases once you get to about 20 or so stocks. And top value investor Whitney Tilson, citing Greenblatt’s book, said that “owning two stocks eliminates 46% of non market risk of just owning one stock.” As you add additional stocks to your portfolio, that non-market risk declines as follows: - Owning four stocks eliminates 72% of the risk - Owning eight stocks eliminates 81% of the risk - Owning 16 stocks eliminates 93% of the risk - Owning 32 stocks eliminates 96% of the risk - Owning 500 stocks eliminates 99% of the risk “Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there’s obviously a big penalty in terms of performance if one’s best ideas are 3-5% positions instead of 7-10% positions.” wrote Tilson. Below I share with you what Thomas Moore, editor in chief of Rebel Income, has to say about diversification and concentration or what he calls “accumulation,” here’s Thomas: --------------------------------------------------------------- Week 10: Diversification or Accumulation? If you’ve invested in the market for any length of time—even more especially if you’re participating actively in your 401(k) plan at work—you’ve been given extensive indoctrination about mutual funds and the “advantages” they offer the average investor. One of the big selling points that mutual fund proponents always point to is the diversified makeup of a fund that occurs as a natural result of its size. With assets of hundreds of millions of dollars (or, in many cases, billions) to invest, and also restricted by SEC regulations about the size of any single position the fund acquires, the only choice funds generally have (unless they are specifically designed to focus on one area or segment of the market) is to develop a portfolio with a wide range of stocks from practically every sector and industry in the market. What about those of us that choose to work directly with individual stocks? Is there a similar advantage that we as retail investors can build for ourselves without actually buying a fund? Perhaps even more important is whether diversification really provides the advantage that funds want you to believe they do. As an income investor, diversification might not seem like the most productive way to generate useful, consistent income. If you’ve been subscribing to this blog for the last several months, you’ve noticed that at different points, I tried to leverage some of the stocks I had accumulated from my put selling trades by selling puts again on those same stocks. The logic was to possibly increase the size of my position in that stock while at the same time lowering my average cost (these are stocks that had experienced major drops from my assignment levels). Once those companies began to recover, my lowered cost meant that I wouldn’t need to wait as long to see their stocks reach a point where I could sell covered calls or simply close the position altogether. I think there is a reasonable balance between trying to diversify the stocks in your portfolio and making sure that the positions you do accumulate are significant enough to give you a satisfactory result. My goal with today’s post is to talk about how to find where that balance lies. I want to start by talking about both side of the diversification argument more specifically. Diversification: The Pros The biggest advantage diversification offers is the same one that every mutual fund company or investment advisor parrots ad nauseam. Having multiple stock positions, spread across multiple industries and sectors of the market should mean that no single stock position will drastically damage your portfolio if it experiences a major drop in price. With a mutual fund, this is an easy concept to make sense of, because funds generally hold hundreds, if not thousands of stocks in their portfolio at any given time. For average investors like you and me, this particular advantage is less significant, simply because few of us have sufficient assets to be that diversified. That isn’t to say that diversification, even in a smaller account, isn’t useful. One of the biggest reasons I like to diversify my trades into different areas of the market comes down to the simple fact that investment dollars in the market ebb and flow from one industry to another as the market cycles from high to low and back again. That means that while stocks in one industry might generally be moving down, stocks in another industry will be moving up. I’ve written about top-down analysis in the past and how finding industries that have been dropping but seem to cycling back to the upside often present good opportunities from both a value and income perspective. Having even just a few stocks in different industries is a good way to leverage diversification in a positive way, which is why that I generally try to highlight stocks in different industries from week to week. It makes it easier to continually find new value-oriented opportunities no matter what the broader market conditions actually are. Diversification: The Cons For the last decade and a half, I really haven’t bought into the popular, mutual fund industry-fed idea that wide diversification works as a risk management tool. Mutual funds and investment advisors would have you believe that by being widely diversified, they will be less sensitive to major changes in the marketplace. They seem to like to use the industry and sector rotation logic I just described to try to convince you that their funds will outperform the market when things go south. Here’s the truth: if and when the market turns from strongly bullish to strongly bullish, just about everything will go down. The kind of sea changes that mark the end of a long bull market and the start of a new bear market tend to affect all industries (with the exception of certain industries that generally have a negative correlation with the market, like precious metals), if not equally, then at least with the same lack of mercy. The biggest horror story I have about my investments comes from the “Internet bubble” days of 1999 and 2000. At the time, I was an enthusiastic proponent of mutual funds and had all of my retirement savings tied up in mutual funds. I had been careful about selecting funds that I thought gave me a very broad diversification profile. When the market turned bearish in 2000, I watched all of the funds I was invested in drop almost as fast—and in a few cases, faster—than the market itself. From its highest point in March 2000 to its low in October 2002, the S&P 500 dropped about 50% in value. Logically, my diversified funds should have dropped less, right? Well, the truth is that I lost about 70% of my retirement savings over that period because despite the “diversified” approach my funds took, they were still going to follow the market lower (the larger loss came because most of those funds actually had overbalanced their portfolios in the trendiest dot-com stocks at the time, many of which no longer exist). The moral of the story is simple. Don’t diversify your portfolio because you think it will help you manage risk more effectively – that just isn’t true. If you want to diversify, do it because you want to maintain the flexibility in your account to take advantage of opportunities throughout the market, where and when they come. When you accumulate more shares in fewer stocks, you have less flexibility to put your money where the market is moving. When I’ve written about position sizing, I’ve recommended using 5 – 8% of your available capital as a conservative benchmark. Make sure that the number of shares you might have to buy from a put sale assignment, for example, will tie up no more than 5 – 8% of your account’s total buying power. That gives you a good, generalized way to keep any single position from being so large that you can’t sell a new put option without unwinding a trade or selling a stock you’ve been assigned, possibly before you want to. It also naturally lends itself to what I think is a realistic limit for how far most retail investors should try to diversify their portfolios. Accumulation: The Pros It’s easy to think that accumulation—buying more shares to hold larger positions as a percentage of your available capital—is the opposite of diversification. In the broadest sense, I guess that’s true, because as I just observed, taking on larger individual positions means that you will own fewer stocks, which means you have less diversification. That said, there is a time and place where sometimes being willing to sacrifice some diversification for accumulation is smart. If you’ve been assigned a stock from a put sale, and the stock has seen a significant drop in price (it will usually need to be several dollars per share), but the company’s fundamental strength is unchanged, there is usually an opportunity to start thinking about accumulation more seriously. In this kind of scenario, the drop in price can usually be attributed more to market dynamics than problems with the company itself, which means the original opinion of the company’s actual value—what got you into the trade in the first place—should still be valid. Selling another put option at this point should provide a nice immediate yield for that trade (the drop in price should inflate the Bid prices for put options) which by itself can be used to lower your net cost in the stock position. It also opens the door to buying more shares at that option’s strike price. If you are assigned, you can average your two assignment prices (less the put option premiums you’ve brought in) to arrive at a new net average cost. Now you have more shares, at a lower price that you started at. A recovery in the stock will return you to profitability for the position and let you sell covered calls above your average cost more quickly. Accumulation: The Cons The cons for accumulation really apply in the opposite sense to what diversification does for you. Holding more shares means that even small stock moves give you a bigger net result, but by accumulating more shares, you do have to be willing sacrifice some of the flexibility you may have intended to maintain by using conservative position sizes. It also means that if the stock doesn’t recover quickly, the paper loss for that position will have a larger visible affect on your account. This is really the biggest reason I’ve been pretty selective about the times and cases I’ve tried to apply it on my existing positions. You should really only apply it if 1) the stock in question has dropped far enough in price that selling a proportionate number of new contracts gives you a significant change in your average cost, and 2) your fundamental analysis of the underlying company remains firm. If there is any uncertainty in the company’s long-term strength, don’t sell a new set of put options on the hope it will recover. You would probably be better off in this case just closing the position and moving on to something else. It’s important to understand the impact the size of your stock positions will have on your total portfolio. It’s one of the reasons I favor taking a conservative approach to position sizing. I also believe, however, that it is perfectly reasonable to give yourself a little room to make adjustments to your position approach when the conditions seem like they may be worth it. Make sure that you understand what your basic reasons and motivations are for the rules you put in place as well as what you may be exposing your account to when you decide to make an exception. That way you’ll always be aware of what you’re getting into. --------------------------------------------------------------- It seems that great value investors agree, over diversification is not only unnecessary, it hampers your overall returns.  We believe Thomas’ ability to concentrate his holding into a handful of quality companies trading at 40 to 60 cents on the dollar is a big reason he has substantially [outperformed the S&P 500] over the last two years. We also believe that one of the best ways to acquire shares in deeply undervalued companies is by first selling put options with the potential of being assigned shares. And when you’re not assigned you just collect the income and sell another put option. In today’s low-rate, stagnant economy, I don’t believe there is a more important strategy you can learn than to successfully sell put options on undervalued quality companies. Regards, Shane Rawlings Co-Founder, Investiv [No Comments »] | Filed under: [View all posts in Diversification], [View all posts in Investing Strategy], [View all posts in Investiv Daily], [View all posts in Options], [View all posts in Sunday Edition] | Tags: No Tags --------------------------------------------------------------- If you are having trouble reading this email, you may [view the online version] This email was sent to {EMAIL} by Investiv, LLC 3400 North Ashton Blvd. | Suite 170 | Lehi | UT | 84043 [Forward to a friend] | [Unsubscribe] Disclaimers Investing is Inherently Risky There are risks inherent in all investments, which may make such investments unsuitable for certain persons. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. You may lose all of your money trading and investing. 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