The Dissipating Returns of Diversification

“Set it and forget it!” — Ron Popeil

My first year as an investment manger for the family office was, to quote Sinatra, “a very good year.” 31% return vs. 9.4% for the S&P 500. I concentrated solely on spinoffs for reasons I outlined in an earlier post, Stock Spinoffs: Fertile Ground for Value Investors. At the end of the year, this left me with 5 stocks. Surely I needed to diversify? As I added two new strategies and more stocks, returns went down.

What was the problem with my initial portfolio/strategy? The return was spectacular, but the action was boring. That’s it. It was boring. Initial success can lead to a certain amount of hubris as well. It’s been said the Devil will find work for idle hands to do. Indeed.

Out of nowhere, the good idea fairy showed up. She had me researching the shameless cloning and uber cannibal strategies of legendary investor Mohnish Pabrai as well as formulating additional strategies of my own. I built two new portfolios to run alongside the spinoffs. One comprised entirely of debt-free companies, and the other loosely based on Pabrai’s shameless cloning, but focused on ‘Activist’ investors. The number of stocks I held quickly grew from 5 to 25. Even though we are early into the 2nd quarter of 2017, I noticed returns started to diminish.

But my spinoff portfolio only had five stocks in it. I felt too concentrated. I remembered the old saw from Peter Lynch, “The best stock to buy may be one you already own.” This was great for reallocation as I trimmed down my other holdings, but it didn’t really solve my dilemma on proper diversification. I reached out to friend and legendary investor Guy Spier of Aquamarine Fundfor his thoughts on diversification.

Guy told me he generally likes the 5% number. It’s large enough to be meaningful and not so large if things drop there’s a large impact, e.g. if 5% goes to 2.5%, that is not terrible. If it doubles, it goes to 10%, which is a meaningful gain. Though with 10%, a 50% drop can be painful. Guy noted if your position is only 2.5%, moves up or down hardly make an impact.

Guy’s comments hit me on the head like a sledgehammer. I had it backasswards. Proper diversification isn’t about the number of holdings; it’s about position size and the impact to the overall portfolio. Thanks to Guy, I was able to make early course corrections and am now back on track for 2017.

For those of us who love all things investing, and who all want to be like Warren (and Guy and Mohnish), tap dancing our way to work; new ideas, disruption, innovation, a thousand shiny objects, etc. end up spreading you too thin. It can seem like every time you get out, they drag you back in. If you have a strategy that’s working for you, don’t mess with it. Get a hobby. Get a dog. The best investing advice ever may actually come from a late night infomercial: “Set it and forget it!”

1lazy

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