April 3, 2014 Leave a comment
I’ve recently been searching for an answer to what I actually believe when it comes to managing money. I previously and still do believe that with unsophisticated, risk averse individuals, or individuals in the “retirement red zone”, a simple, diversified ETF portfolio is still the most appropriate.
However for individuals or institutions who are 1. Younger (> 10 years from retirement/whatever the goal for that pot of money is) 2. Risk seekers who prefer to take a chance 3. Client’s who truly believe in giving their advisor full discretion when it comes to managing their money (not constantly bugging them, asking why didn’t we sell here, why didn’t we buy here…etc) 4. Clients who believe that advisors who simply use asset allocation targeting via ETFs and Mutual Funds do not deserve their fee as they’re “not doing anything I couldn’t do” 5. Institutions with long term/perpetual money or the need to rapidly increase their funds to be able to fulfill an obligation or 6. Retirees who simply want to get maximum income through a growing dividend stream… I believe that a portfolio of 10-30 individual equities could be appropriate.
The issue most people have with owning individual equities is they believe that they are taking an unnecessary risk by not being as broadly diversified as they would be with funds. However what most individuals fail to grasp is the fact that although diversification does reduce downside risk, it does so by also reducing upside potential, otherwise there would be an uneven risk-reward tradeoff that everyone would exploit (because it’s easy to get access to). They are sometimes correct in their thinking that a portfolio of individual stocks can result in unnecessary unsystemic risk, however that’s because the majority of advisors who attempt to build those types of portfolios try to target broad diversification the way mutual funds. That’s where the problem lies. By attempting to select companies from every different industry they are bound to include some companies they do not fully understand. No single individual is going to have a deep understanding on every sector, country, and firm’s risks and catalysts, so by targeting firms from every sector they are playing a dangerous game in the name of diversification. Thus by pursuing that route of diversification, they are actually adding to the risk of the overall portfolio because they do not fully understand all of the risks associated with their stocks. I call this risk “ignorance” risk.
I believe that a portfolio built by using stocks that operate in an individual’s “circle of competence”, while not necessarily providing the static definition of diversification, can actually provide superior protections without hindering the upside potential. This is because if the stocks that are selected are selected from industries and firms that the individual truly understands, he is eliminating the possibility of utilizing something he does not understand, thus reducing the risk of being exposed to some tail risk that he never expected. The reason we do not see this very often is because it takes effort and time in order to create this circle of competence. I currently am in the beginning phases of compiling my circle of competence and am beginning to realize how much of an undertaking it is. The best way for me to keep my head around it is to write out my process below and use this giant post, that I hope no one ever reads, to keep my thoughts organized.
Circle of Competence – Categories:
Gaming – video game producers, platform makers
“Future” – 3d printing, TSLA and suppliers, emerging tech software/hardware
Internet – Social media, internet conglomerates (GOOG, AMZN, YHOO)
Alcohol – DEO, BUD, SAB, BEAM…
Casino – US plays based on increasing acceptance in gambling laws, Int’l (Macau exposure)
International Conglomerates – Provide a more stable exposures
Already considered in my “circle of competence” – Insurance companies, Autos
Now I know there’s no way I will get to know all of those industries deeply but I believe if I can get a handle on most of them, a portfolio made up of Video game, Internet, “Future Tech”, Alcohol, Insurance, and multi-nationals could provide similar downside protection that a fund can deliver via broader diversification, however I believe my portfolio will not reduce upside potential as much because it’s not overly diversified.
The only reason I’m actually posting this is because it will keep me accountable. Even if no one ever reads this, as is my intention, the fact that I have written out my thoughts, and published it in a public forum will be much more likely to keep me accountable as this is something I really want to pursue.