A recent story at Market Watch discussed the fact that rich people often diversify their investments poorly. Not mentioned is the fact that many people get rich through concentrated bets. But that’s a bad reason to do the same. There are good reasons to look to successful people to see what they do well. However, using successful people as role models isn’t always a good idea. A common way for investors to get rich is to make an extremely risky concentrated bet and get very lucky. However, for each person who takes a wild chance and gets rich, there have to be many more who take wild chances and lose almost everything. It’s hardly surprising that people who get rich taking big chances would have a tendency to continue to take big chances. Others who try to copy this behaviour are likely to lose badly. If the rich role model was simply lucky, the next person probably won’t be lucky. If the rich role model succeeded through genuine skill, the next person probably doesn’t ha...

Some investment experts advocate maximum diversification, which others deride it as “di-worse-ification.” In Ben Carlson’s recent article , he is somewhere in the middle saying you need to find the “right balance between eliminating unsystematic risk (risk that’s specific to single securities or industries) and di-worsification by adding too many overlapping funds.” Who is right? Your answer depends on your views on active investing. At one extreme, suppose you knew for certain you’ve identified the one stock that will go up most in the next year. You’re not 90% sure or 99%. You’re 100% sure. Then you’d be crazy not to invest everything you have in that one stock. Of course, you’d also have to be crazy to be this certain about the stock. As our crystal balls become cloudier, the need to diversify arises. Maybe you decide to put some of your money into other stocks, even though you have less confidence in these other stocks. You’ve decided that the protection against possibl...

In my quest to find different ways of explaining investing concepts, I have a new idea for explaining the value of diversification based on a hypothetical game show. It shows the trade-offs between concentrating your bets and spreading them out. You’ve beaten the other contestants to make it to the prize round of the TV game show “No Guts—No Glory” to take a shot at winning up to a million dollars! There are five briefcases, each containing a different amount of money: $100, $1000, $10,000, $100,000, and $1,000,000. But they are in a randomly-selected order. You can choose any number of briefcases from one to five, but none are opened until you’ve finished making your selections. The catch is that you get the average amount in the briefcases you pick, not the total. So, if you choose 3 briefcases that happen to contain $1000, $10,000, and $100,000, your prize is not the total of $111,000 but the average amount of $37,000. (Fun fact: no matter what the briefcase selection, th...

The most common explanation of the value of diversification is avoiding big losses. Investing everything you owned in Nortel stock before the bankruptcy would have been a disaster. However, there is another side to the value of diversification. Josh Brown reported that many are blaming active fund managers’ failure to keep up with markets in 2014 on Apple’s success . Apparently, many fund managers owned proportionally less Apple stock than its percentage in the index. This failure to own high-flying shares is the other side of the benefits of diversification. In any given year, there are relatively few stocks that give huge gains. If you only own a few stocks and choose them essentially randomly, there is a good chance you’ll miss all the big winners. The advantage of an index is that it always gets its share of all stocks, including winners and losers. Keep in mind that a “winner” is a stock that performs better than the index, and a “loser” earns less than the index. The...

I recently revealed my portfolio’s asset allocation and the reasoning behind it . It consists of just 4 Exchange Traded Funds (ETFs). This might make some think that I’m not sufficiently diversified. To explain why this isn’t true, I’ll take a deeper look at these ETFs. I’ll also go over many of portfolio costs that investors face. The following chart gives some basic information about the ETFs in my portfolio: ETF Allocation Asset Class # Stocks MER Purchase Currency VCN 30% Canadian 248 0.05% C$ VTI 25% U.S. 3772 0.05% US$ VBR 20% U.S. Small Cap Value 812 0.09% US$ VXUS 25% World ex. U.S. 5783 0.14% US$ Diversification If we focus initially on the “# Stocks” column, we see that each ETF contains within it a large number of individual stocks....

Most commentators agree that the stock portion of our portfolios should consist of many stocks in order to reduce volatility. Where they disagree is on how many stocks are needed to be adequately diversified. Over the years, the trend has been for the recommended minimum number of stocks to rise. I have an explanation for this trend. In 2009 Tom Bradley wrote "While a portfolio of 20 stocks and a few government bonds were just fine for our parents a generation ago, it’s probably not enough today." Why would the minimum number of stocks we should own change over time? With each stock you add to a portfolio, the volatility tends to decrease. However, the amount of benefit drops off as the number of stocks rises. Adding a second stock gives a big reduction in volatility, but adding a 101st stock doesn't reduce volatility much. For indexers, there is no such thing as too much diversification as long as the cost of ownership (fund MERs) stays low. So, an index in...

A friend I’ll call Jake was analyzing his investments and posed the following question (lightly edited): I’ve got a standard mix of ETFs, including XIC, XIN, XSP, XBB, and XRB, each with a target percentage of my portfolio and a plan to rebalance when things get out of whack. I plotted the value of my portfolio against the TSX. Guess what? All three lines are almost identical. The correlation isn’t perfect, but close enough over any time period. So what has my “diversification” and “balancing” bought me (aside from extra transaction fees)? Are markets so tightly interconnected as to make “diversification” impossible/meaningless? When was the last time you saw the S&P go one way but the DOW and/or NASDAQ go the other? Is there any advantage to carving off a chunk of cash and investing in a sector or part of the world? Logic says yes, but the results say no. I won’t give up on my diversification just yet, but if I was giving advice to a newbie it might be “buy XIC and s...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. In an earlier post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility . The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get. One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear. Let’s go back to the example in the earlier post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everythi...

In my previous post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility. The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get. This explains the inconsistency among various reports of average stock market returns . One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear. Let’s go back to the example in the previous post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everything over 3 years, even though the average outcome is ...