Diworsification - Why I Run A Concentrated Portfolio
Diworsification - Why I Run A Concentrated Portfolio
The 60/40 Portfolio Is Dead, And Ideas On What To Do About It
Summary
The 60/40 stock and bond portfolio has long been considered a diversified all weather portfolio.
While past returns have been attractive, things don’t look as good moving forward.
The real returns of the 40% bonds side will be hurt by inflation.
The 60% stocks side will also feel inflation, but the standard S&P 500 allocation isn’t actually that diversified. It is concentrated in the largest tech companies.
In my opinion, many investors are over-diversified. Investing is not a one size fits all approach, but I prefer a concentrated portfolio.
The other day I went down to my cigar lounge in Seattle to relax and watch the Kraken game. I’m more of a baseball fan (and a long-suffering Mariners fan), but I enjoy watching hockey and it was a good Game 1 to start their series against the Dallas Stars. They won in overtime but lost last Game 2 last night. After the game, we had a long conversation on markets, finance, interest rates, and geopolitics.
I love talking about all these topics, and quite frankly, I think most people don’t have enough of these conversations. In recent days, we have seen another 25-basis point interest hike and the collapse of First Republic Bank. That’s not the focus today, but from what I have heard, it sounds like there are other banks circling the drain and I’m sure we will be finding out more about the banks in coming weeks. We also discussed inflation, China, Ukraine, and some of the stocks that I think will perform well over the next 3 to 5 years.
I spend a lot of time thinking about macroeconomics and where the world is headed over the next couple years. Everyone has some view on these topics, but for investors, it’s important because it will have an impact on your strategy. In recent years, the 60/40 stock and bond portfolio has been considered a good all-weather strategy where investors could set it and forget it. I don’t think that will be the case moving forward, for several reasons.
Over the last couple decades, the 60/40 stock and bond portfolio has basically become financial industry standard. I think part of this due to the laziness of most financial advisors. The other part is likely due to how well the standard 60/40 portfolio performed in recent years. 2022 was actually the worst year on record for the 60/40 portfolio, and I think it was a sign of things to come. In my opinion, there are problems on the horizon for both sides of this portfolio.
40% Bonds
I talked about bonds briefly in my inflation post, but I think that a lot of advisors and investors are not factoring in the drag on bonds from inflation. Part of that is due to recency bias, which is hard to break after a forty-year bond bull market and relatively low inflation, but I think that the next decade is going to look a lot different from the last one. Bonds are considered a safe and low-risk investment (especially Treasuries), but if you are trying to grow your wealth over time and increase your purchasing power, bonds don’t look like a good risk/reward proposition moving forward. They are certainly more attractive than they were when interest rates were near zero and bonds represented return-free risk, but on the whole, I still don’t find the asset class attractive today.
In the past, bonds would perform well when stocks struggled, cushioning any drawdowns that happened in the stock market. However, if we look forward instead of using the rearview mirror, I think bonds will generally be a rough place to invest due to higher inflation. To be sure, bonds will do well if interest rates fall again (which many pundits are predicting), but I don’t think they will beat the rate of inflation. If you buy bonds yielding 5% and hold them to maturity, when inflation is averaging more than 8%, the nominal value of this part of the portfolio will increase. However, this won’t keep up with inflation and the real purchasing power will actually decrease.
For a simple illustration, we can purchase $1,000 of 1-year Treasuries, yielding 4.59% as I write this. In a year, it will be worth $1,045.90. If inflation over that same time period is 8%, your purchasing power actually decreased over that year. If you decided to go to Costco at the beginning of the year to buy $1,000 worth of groceries, you would get more bang for your buck than if you did the same thing after a year with $1,045.90. This brings me to the concentration risks that I see with the stock side of the portfolio.
60% Stocks
I have talked about a bit about the cyclical nature of markets, and I plan to write a post dedicated to the topic. For now, I think we are closer to a cycle peak than a cycle trough when it comes to most stocks simply due to valuation. I like certain sectors more than others, and these sectors are not a meaningful percentage of most 60/40 portfolios. The standard option for the stock side of a 60/40 portfolio is an S&P 500 index, the market cap weighted index of the largest companies in the US.
The problem with the standard S&P 500 index is that it is heavily concentrated in the tech sector, which is richly valued today. Of the top 10 companies in the index, 8 companies are large tech companies like Apple AAPL 0.00%↑ and Microsoft MSFT 0.00%↑ . If you invested $1,000 in the S&P 500 today, nearly 25%, or $250 will be invested those 8 companies. Some of those stocks are more overvalued than others (namely Tesla TSLA 0.00%↑ and Nvidia NVDA 0.00%↑ ), but the whole group is richly valued today.
The set it and forget it passive investing strategy of investing in the S&P 500 has been extremely successful over the last couple decades, but like my view on bonds, I don’t think that will continue for the next decade. There are some alternatives to the S&P 500, but the main one that comes to mind is well-known Nasdaq 100 ETF QQQ, which is even heavier with its tech sector weighting. If you want to invest in the S&P 500 without the concentration, there is an equal weight S&P 500 ETF RSP 0.00%↑ , which invests the same amount in the smallest companies in the S&P 500 as it does in the large companies. I think this will generally be a better option moving forward, but I would rather look for the individual companies that I think will outperform all of these ETFs.
Keeping Wealth vs. Building Wealth
Depending on where you are at, your approach to building an investment portfolio is going to be different. For investors that are already wealthy, they tend to be more risk-averse and focused on avoiding large losses. Investors focused on building wealth tend to take more risk in an attempt to increase their returns and build their portfolio in an attempt to build their wealth over time. Either way, I don’t think the 60/40 portfolio is a good fit for most investors moving forward. It might be diversified, but if both sides of the portfolio don’t perform well enough to keep up with inflation, it’s not a good investment strategy for long-term investors.
Diworsification
Diworsification is a term coined by fund manager Peter Lynch. It basically describes what happens to most investors invested in various ETFs and mutual funds, which own a slice of many different assets but reduces the risk/reward profile of the overall portfolio. To be clear, I’m not saying that anyone should put all their eggs in one basket and just buy one stock in an attempt to maximize returns. I own more than 20 stocks, but the lion’s share of my investment portfolio is in 5 or 6 companies that I find very attractive opportunities over the next 3 to 5 years.
Each investor’s portfolio will be different depending on their mindset, but I think a stock portfolio can be sufficiently diversified by owning as few as 5 stocks. It doesn’t make sense to own just 5 energy stocks or 5 tech stocks, but if you spread things around to different businesses and sectors, you can generate impressive returns if you are intelligent in your investment decisions. Once you go past 20 stocks, it starts to have a drag on the returns if you assume each stock is an equal percentage of the portfolio.
Generally, I think investors should own more of the stocks that they find most attractive. A diversified 60/40 portfolio has worked well in recent years because everything has gone up and to the right, but I don’t think the risk/reward is favorable today. Right now, I’m leaning heavily towards the energy sector because that is where I think the most attractive opportunities are, but I’m sure in the future other sectors will look more attractive compared to energy.
It comes down to opportunity cost. Would I rather own more of my best idea, or do I want to buy a new stock in order to diversify? In theory, diversification lowers the risk of a portfolio, but if you overdo it, it also lowers the potential return. That is where the 60/40 portfolio sits today, and if you think inflation will remain high, your real returns might not be as attractive as they were in years past.
Conclusion
I will be talking about other top picks in the next couple weeks, but Peabody Energy BTU 0.00%↑ is an example in my own portfolio. It’s a large chunk of my portfolio because I think shares will significantly outperform over the next couple years. If I’m looking at buying another stock, does the opportunity make sense for my portfolio, or would I rather just buy more Peabody? That was my mindset when I was buying shares recently.
I want to be clear that this is not a one size fits all approach. There are factors that will influence what you’re comfortable with, including your age and risk tolerance, but I think investors looking to outperform the market might want to consider a portfolio concentrated in their best ideas. I think this is true no matter what is going on in the market, but if you agree with my assertion that a 60/40 portfolio won’t generate attractive forward returns like it has in the past, it might be a good time to reevaluate your investments. Owning a basket of everything in stocks and bonds has worked for years, but that doesn’t mean it will work forever.
Disclaimer
You should do your own research before making any investment decisions. Different investment strategies have different risk/return profiles which should be considered before making any decisions.