In this podcast episode you’ll learn:
- The skills you need to be able to select individual stocks.
- How have active managers outperformed relative to passive indexing products.
- How much diversification is too much and a test to determine if one is over diversified.
- What is factor investing and which factors have worked over the past 200 years.
The idea of over-diversification can be complicated in nature. In its most simple definition, it is when a growing number of investments in a portfolio (which can lower risk) also overly lowers the expected return. You have to weigh whether the lowered risk outweighs the potential cost. In this episode, David unpacks the concept of diversification and answers a listener question about passive versus actively managed funds.
Diversification is a protection against ignorance
Warren Buffet once referred to diversification as a “protection against ignorance”. The majority of the general public does not understand how to evaluate businesses well enough to know how they should be valued. .
So if you’ve already decided you don’t have the expertise to select individual stocks and instead use index funds and ETFs how do you know if you’re over diversified? How do you know that the manager you’ve chosen was the best option? David states, “if you’re paying too much, in terms of the transaction costs and management fees vs. the marginal benefit of reduced volatility, then you’re over diversified.”
An advisor isn’t necessary
As an investor, you have two choices in front of you: investing in a fund with an active manager, or some sort of passively managed fund, such as an index fund, or exchange-traded fund (ETF). According to David, the likelihood of an advisor outperforming an existing portfolio of Vanguard Index Funds is small.
Morningstar, a global financial services firm that performs investment research, made easy work of the subject in a study they performed. In 15 years, only 15% of large-company funds were successful in outperforming the index. With dismal numbers like that, the investment in an active manager likely won’t get you a return on your money. David used to choose managers in his profession and found that even if you find a skilled manager, they too go through lengthy periods of underperformance.
Individual investors should use index funds
Warren Buffett wrote in his 1996 annual shareholder letter that he recommends investing in an index fund that charges minimal fees. This will lead to a higher chance of succeeding.
On the flip side, if you are bound and determined to choose your own individual investments, you have to have the necessary skills to evaluate specific businesses. If you do so, choose industries with your circle of competence. Where does your experience and expertise lie? Work with what you know, and invest in something you are certain will continue to succeed in the next 20 years.
You also have to be able to pinpoint companies that are mispriced and likely to outperform. Not many people are capable of doing that—even Warren Buffet—and it will likely reduce your return. With the market being so volatile it may not be in your best interest to manage individual stocks yourself.
Considering factor investing
A paper titled “Global Factor Premiums” written by Guido Baltussen, Laurens Swinkels, and Pim Van Vliet gave David a comprehensive overview of factor investing over a period of 200 years. What they found was that most factors work:
- Momentum: Stocks that have had high returns will likely continue to have high returns. This study showed that momentum within stocks had a positive Sharpe ratio.
- Value: worked 75% of the time in rolling 10-year periods.
- Trend: The idea that an upwardly biased market continues—worked 98% of the 10-year periods for stocks.
- Seasonality: The fact that there are certain months of the year when stocks do better. This worked in 90% of the 10-year periods.
- Carry: As long as nothing happens, you continue to get paid. Carry worked 95% of the time, on a rolling 10-year basis, in terms of a positive Sharpe ratio for stocks.
- Betting against beta: Volatility relative to a particular benchmark. This also had a positive Sharpe ratio.
These factors are persistent drivers of return. David dives into answer this particular listener’s questions in detail, delving into the positives and negatives, and his thoughts on possible decisions that could be made.
- [2:22] Exploring the concept of over-diversification
- [5:25] Should you pay for an investment advisor to select individual stocks?
- [8:05] An individual investor should choose index funds
- [11:10] Determining how much diversification is enough?
- [13:37] Weighing the cost against the benefits
- [16:10] When being over diversified is possible
- [17:05] Analyzing the listener question regarding over-diversification
- [20:20] A Fascinating study analyzing 200 years of factors
- [25:08] Layer on additional value factor
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