Category Archives: Diversification


How Diversified Should You Be?

  • Extreme diversification is good but only provides ordinary results results.
  • Concentrated portfolios proved better in some cases as they allow investors to select the best companies.


A few days ago we discussed passive and active strategies given that there is a looming risk of a recession and that the markets are unable to break new highs which makes just holding stocks for the sake of holding stocks very risky. In this article we are going to discuss how diversified a portfolio should be as it is easier to pursue an active strategy with a concentrated portfolio of stocks.


Diversification is the process of allocating capital in a way that reduces the exposure to the individual risks of any particular asset. But the question is how much diversification is too much or too little?

On one side we have the “efficient market hypothesis” believers that promote a “market portfolio.” A “market portfolio” is a portfolio that holds every traded asset in the market in proportion to its market value. On the other side we have investors who meticulously search for one, two or three good companies and put “all their eggs in one basket.”

The debate is an ongoing one where Mark Cuban once claimed that diversification is for idiots while John Bogle, the father of the index fund business, adverts massive diversification through his Vanguard funds. As said on the Vanguard web page: “Each all-in-one fund invests in thousands of individual stocks and bonds to help reduce the risk to your investments.”

Let us see how this extreme diversification performed in the last decade.

NameTickerAsset ClassExpense RatioPrice As of 7/1/16
($ Change, % Change)
SEC YieldYTD As of 7/1/16Average Annual Returns: 1 YearAverage Annual Returns: 5 YearsAverage Annual Returns: 10 YearsSince Inception
Federal Money MarketVMFXXMoney Market0.11%$1.00 ($0.00, 0.00%)0.32%0.15%0.18%0.05%1.07%4.41%
GNMAVFIIXBond - Interterm Government0.21%$10.87 ($0.02, 0.18%)1.98%3.24%4.17%3.04%5.01%7.53%
Intermediate-Term Corporate Bond Index Admiral SharesVICSXBond - Interterm Investment0.10%$23.97 ($0.05, 0.21%)2.93%7.77%7.75%5.82%N/A6.43%
Target Retirement 2035VTTHXBalanced0.15%$17.38 ($0.05, 0.29%)2.13%3.21%-0.67%7.44%5.74%6.76%
500 Index Admiral SharesVFIAXStock - Large Cap Blend0.05%$194.08 ($0.42, 0.22%)2.11%4.04%3.95%12.06%7.42%4.88%
Developed Markets Index Admiral SharesVTMGXInternational0.09%$11.38 ($0.04, 0.35%)---1.96%-8.55%2.05%1.92%3.24%
Emerging Markets Government Bond Index Admiral SharesVGAVXInternational0.33%$20.01 ($0.11, 0.55%)4.47%10.45%8.18%----4.08%
Figure 1: Performance of Vanguard funds. Source: Vanguard.

All in all, the results are very positive over the long term. The Federal Money Market fund averaged 4.41% since 1981 but only 1.07% in the last 10 years. Bond funds had average returns of 7% since 1980 and 5% in the last 10 years. As for stocks, the 500 Index Admiral Fund managed to return 4.88% per year even if it was incepted in the midst of the dotcom bubble in 2000.

It can be concluded that there is nothing wrong with extreme diversification. Over the long term it will earn single digits returns, similar to the earnings of the underlying assets. With the current S&P 500 PE ratio at 24, diversified investors can expect returns of around 4% from stocks and 2% to 3% from bonds in the long term. Such returns will for sure beat inflation and keep capital well preserved.

Portfolio Concentration

Diversification opponents state that an investor is limited to mediocre returns if he buys the market, and that much better returns can be expected if the best assets available are selected and nothing is bought just for the sake of buying because it makes up part of the market.

Two great promoters of carefully choosing where to put your eggs are Berkshire Hathaway’s managers, Warren Buffett and Charlie Munger. They state that excessive diversification is madness and because it includes investments in mediocre businesses it only guarantees ordinary results. A look at Berkshire Hathaway’s performance since 2000 will prove that concentration outperforms diversification.

figure 2 berkshire hathaway
Figure 2: Berkshire Hathaway since 2000. Source: Yahoo Finance.

Berkshire Hathaway went from $51,200 in 2000 to the current $216,298. That gives a compounded annual return of 9.4% which beats the returns of all the Vanguard funds. The main ideology behind Buffett and Munger is don’t just buy something because everyone else is. This slight difference is the reason for the few extra percentage return points that create a huge difference in the long term. And still now, Berkshire has a PE ratio of 14.5 which will create better returns in the long term than the general market.

As Berkshire holds companies like Geico, Fruit of the Loom, Dairy Queen, Nebraska Furniture Mart, Benjamin Moore, See’s Candies, Burlington Northern and has investment positions in Wells Fargo, Coca-Cola, American Express, IBM and Heinz, it provides good diversification but not too much.

Buffett’s strategy is in line with the academic market portfolio theory that 20 stocks from various sectors is enough to eliminate stock specific risk from your portfolio and leave you with only market risk. As 20 stocks is not many, and many fewer than the thousands of stocks in the Vanguard funds, you might as well chose the best ones which will bring you additional returns with the same amount of risk.

figure 3 stock market risks
Figure 3: Number of stocks needed to eliminate stock specific risks. Source: Investopedia.

Of course, this does not mean that you can buy 20 different airlines and sleep well, the stocks should be from various sectors and have uncorrelated returns.

No Diversification At All

Some advocate a strategy where you put all your eggs in one basket, but a big survival bias holds this theory afloat. We constantly hear about the various Gates, Zuckerbergs or Ortegas that made huge fortunes by betting on one horse. But that was mostly their horse and we do not hear about the millions that lost it all by betting on themselves in the same way.

In Bloomberg’s billionaire top ten list there are two who arrived there by diversifying, Buffett and Slim.

figure 4 bloo
Figure 4: Bloomberg Billionaires list. Source: Bloomberg.


Let us start with saying that every strategy should outperform holding your capital under the mattress in the long term. Extreme diversification will achieve stable but ordinary results while less diversification and choosing the best companies at the best prices will help your portfolio outperform. On top of that you can be more active with a 20 stock portfolio and buy the cheaper stocks and sell the overvalued ones.


How to Prepare Your Portfolio For The Next Recession or Stock Market Crash

  • The risks of a slowdown are higher than the upside.
  • Fundamental trends are negative in advanced economies while emerging markets show higher growth rates and are cheaper.
  • It is important to create a diversified portfolio with uncorrelated assets.


In an environment where it seems maximum potential for the U.S. economy has been reached, the St. Louis FED chief, James Bullard, has said in his most recent report that he favors only one interest rate increase through 2018, which would at best keep things stable. His view is further supported by the fact that the unemployment rate is sitting at below 5%, and the Personal Consumption Expenditures PCE inflation—measured by the Dallas FED—is at 1.84%, both of which signal that the economy has reached its maximum potential.

1 figure trimmed inflation
Figure 1: Trimmed mean PCE inflation. Source: FRED.

The scary part of the report is where Mr. Bullard describes how forecasts are made based on the current situation, which will most definitely change. What is difficult to predict is the direction of the change therefore, forecasts are bound to be incorrect and under the influence of various risks like a return to the normal Phillips curve influence where low unemployment triggers inflation, or a recession even if no current data indicates the possibility of one. Thus only an extremely positive scenario would trigger interest rate increases if fundamentals like inflation or productivity stay stable.

2 figure fed stlouis
Figure 2: St. Louis FED’s U.S. macroeconomic outlook. Source: St. Louis FED.

The conclusion is that practically anything can happen, and the FED has absolutely no idea as to where the economy will be in a year or two. Even FED Chairwoman Yellen admits that the 2013 expected interest rates of 4% for 2016 were too high and that an aging society and a slump in productivity growth will keep the subdued economic indicators persistent.

In such an uncertain environment, an investor should look at the best ways to protect his downside and maximize his upside.

Investment Ideas

Let us start with bonds where interest rates have been declining since the start of this century.


3 figure bonds
Figure 3: 10-year government bonds yields. Source: Wall Street Journal.

As bond prices are inverse to bond yields, any increase in yields would precipitate bond prices, thus bonds are currently low yield and high risk. Usually considered safe havens in recession times, bonds currently do not provide such protection as it is better to keep cash than bonds with negative interest rates. There is the option of further bond price increases, but that is a highly unlikely scenario as bond yields are at historical lows.

The Stock Market

The S&P 500 is still holding well, but does not manage to break the previous highs despite having come close several times.

4 figure s&P 500
Figure 4: S&P 500 in the last 12 months. Source: Bloomberg.

The S&P 500 dividend yield is 2.12% which might look tempting when compared to the extremely low bond yields, but it is meagre when compared to the historical mean of 4.39%. A return to the mean would result in a drop of 50% or more of the S&P 500 index. The conclusion here is the same as with bonds: High risk, low returns.

But there is an option with stocks that should limit the downside. Dividend stocks that will not see their cash flows affected by a slowing down in the economy are always assets toward which investors run when trouble comes. Examples can be found in telecommunication, consumer staples and healthcare.

Emerging Markets

If the reason for economic stagnation in the developed world is an aging society, slow productivity growth and emerging markets competition, a contrarian thesis would be to invest into emerging markets.

Emerging markets have a relatively young population and are currently shunned by investors as too risky amidst a commodity price slump. But no matter the current issues, the World Bank expects emerging markets and developing economies to grow at rates north of 4% in the long term, while advanced economies are expected to grow below 2%.

Currently, advanced economies are preferred by investors as they regard them as secure, but long term structural trends are strong in place even if we do not choose to see them. What China has done in the last 15 years could be the same as India is about to do. Brazil will probably also return to growth someday.

The following figure will show that the current developed world impression of asset security is mostly funded by debt which is unsustainable in the long term.

figure 5 investment position
Figure 5: U.S. net international investment position. Source: Bureau of Economic Analysis.

On top of that, emerging markets are much cheaper than developed ones according to the Cyclically Adjusted Price Earnings (CAPE) ratio which takes into account earnings from the past 10 years.

figure 6 global cape
Figure 6: Global CAPE map. Source: Star Capital.

For long term investors, the less risky option might be to dig for good investments in emerging markets with positive demographics and a strong growth outlook. Currently those investments are out of favor, but this is exactly the environment where investments give the best returns.


Gold is a doomsday investment, it protects you against inflation and is the metal that surges in difficult times. Typically as the economy does well, stocks grow and gold declines because gold has no yield. The opposite happens in turmoil.

7 figure guardian precious metals
Figure 7: Gold and stocks cycle. Source: Guardian Precious Metals.

You can invest in gold by buying it physically, through ETFs or by buying gold miner stocks.


As always, good diversification should provide sufficient downside protection but a portfolio has to be diversified with uncorrelated assets.

If you have Ford in your portfolio and then you add some Caterpillar, that is not real diversification. Gold, emerging markets, cash, and quality stocks should enable a portfolio to weather economic hardships.

Don’t forget that after every recession comes a recovery, so be ready to increase your exposure to stocks when assets are cheap, even if everyone will be thinking that there is no tomorrow.