EP44: The Truth About Diversification

Ever wondered how much diversification is truly necessary to achieve a low-risk, high-return investment? Brace yourself as we turn conventional investment wisdom on its head in this episode. I'll walk you through my 12 Rules of Simply Investing aimed at minimizing risk and maximizing gains. Plus, we delve into the pitfalls of over-diversification, setting the record straight on how much variety you really need in your portfolio.

I cover the following topics in this episode:
- Our approach to investing
- Conventional wisdom regarding diversification
- What's wrong with too much diversification?
- How much diversification do you need?

 Link to My Take on Diversification and Risk: https://www.simplyinvesting.com/blog/32573-my-take-on-diversification-and-risk 

Watch till the end to get 10% off coupon code for Simply Investing.

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Transcript

Speaker 1: 0:00

In this episode, I'm going to show you what's wrong with too much diversification in your investment portfolio. Hi, my name is Kanwal Sarai and welcome to the Simply Investing Dividend Podcast. In this episode, we're going to cover four topics. First, I'm going to begin with our approach to investing. This is important to know because that's going to help us in the following topics. So the next one is conventional wisdom as it relates to diversification when it comes to investing. Then we're going to look at what's wrong with too much diversification in your portfolio and then, section number four, we're going to look at how much diversification do you really need when it comes to investing? Okay, so let's get started with our first topic our approach to investing. So our approach to investing and what I teach, and have been for over 20 years, is really to teach you how to build a portfolio safely and reliably for the long term. So we're not day traders, I don't teach day trading, I don't advocate day trading and so we're looking at the long term, where we don't think in terms of days, weeks or months. We think in terms of years and decades when it comes to building a safe and reliable dividend stock portfolio. And the key here is not the stock price, but how to build a portfolio that's going to generate consistent and growing dividend income for you year after year. Now our approach is going to help you to lower your risk, maximize your gains, eliminate your fees and reduce the amount of time you spend on your investments. I know you're busy and you don't have hours and hours a day, or even hours and hours a week, to spend on your investments. So the goal here is to keep it simple, but help you become a successful investor. So how do we do this? We help you and I help you to learn how to invest in quality dividend stocks when they're priced low. So we don't want to invest just in any stock. We want to make sure it's a dividend stock, but not any dividend stock. We want to make sure it's a quality dividend stock and then we want to make sure that the stock is priced low when you're ready to invest. Stock prices go up and down all the time. We want to make sure we're buying when the price is low. We do not want to buy when the stock price is up here and it's overvalued and priced high. So how do you know when you're looking at a stock or a company. How do you know that it's a quality stock and that it's priced low? So to help you with that, I've created what I call the 12 rules of simply investing, and these rules are going to help us in the next topic, the couple of sections and topics we're going to talk about in this episode. So this is key. I want to make sure that you understand the 12 rules, because you have to understand our approach to investing, and then we're going to figure out why diversification or over diversification becomes a problem. So if you're watching this, you can see the 12 rules up on the screen. If you're listening to this podcast, I'm going to read out the 12 rules to you in just a minute.

Speaker 1: 3:41

Okay, so here's how this works. Before you invest in any company or in any stock, you want to make sure that it passes all of the 12 rules, and not just 8 out of the 12 or 7 out of the 12. It has to pass all of the 12 rules. So this becomes your checklist, and if a company is failing even one rule, skip it, move on to something else. Why? Because we want to make sure that your money is safe. You're not putting it at very high risk, so we want to lower your risk. We want to maximize your gains. These rules are designed to lower your risk and maximize your gains, so I've been using these personally for over 22 years, and this is what's going to help you become a successful investor Invest safely and reliably for the long term.

Speaker 1: 4:35

Okay, so we're going to go through the 12 rules and then we're going to jump into our next section. So rule number one do you understand how the company is making money? If you don't, skip it. Move on to something else. Rule number two 20 years from now, will people still need its products and services? If they don't, or you think they won't need those services or products, skip it, move on to something else.

Speaker 1: 5:02

Rule number three does the company have a low cost competitive advantage? Rule number four is the company recession proof? We only want to invest in companies that are recession proof, because we never know when the next recession is going to happen, when the next market downturn is going to happen and if I shouldn't say if when the next downturn and next recession happens. You don't want to own stocks that drop in value too much or stocks that cut their dividend when there's a market downturn. So rule number four. That's why we have it. There Is the company recession proof. Rule number five is the company profitable? So we look at the last 20 year history. Does it have a track record of profitability?

Speaker 1: 5:49

Rule number six does the company consistently grow its dividend? So, for example, coca-cola has been increasing dividends consecutively for more than 52 years, right. So we look at the track record before we invest in any company. Rule number seven can the company afford to pay the dividend? Rule number eight is the debt less than 70%? Rule number nine we want to avoid any company that has had a recent dividend cut.

Speaker 1: 6:18

Rule number 10, does the company buy back its own shares? And rule number 11, this is where we look to see if the stock is priced low or priced high. So we want to make sure we're only buying when the stock is priced low. So there's three things we look for here. We check for the PE ratio, we compare the current dividend yield to the average 20 year dividend yield and then we look at the PB price to book ratio and if those three things are all good and it passes, then the company passes.

Speaker 1: 6:49

Rule number 11. And rule number 12, keep your emotions out of investing. I know that's very hard, difficult, easier. It's easy to say, but hard to do. That's what I'm getting at, but it's important. So you want to keep your emotions out of investing. That's why we have the 12 rules. This is the checklist. So it doesn't matter if you're in love with a company or in love with a stock. You want to make sure it passes the 12 rules before you invest in that. So let's move on to our next topic here.

Speaker 1: 7:23

So what does conventional wisdom say when it comes to diversification? And you've probably heard this over and over again and conventional wisdom states that you need to diversify in order to lower your risk when it comes to investing. So sure, I think that makes sense. However, over diversification is a problem, and I'm going to show you why. So that's what I need to get across here with you. The problem is when there's too much diversification in your portfolio. So stick around, we're going to talk about that and you're going to understand why I'm making that kind of statement.

Speaker 1: 8:09

So let's take a look at a couple of funds here. Okay, I've picked some out. They're up on the screen here and you can see. For example, at the top of the list here we have Vanguard Total International Stock Index Fund, the VTIAX. This fund owns over 8,000 companies. That is a lot of companies. So they own stock in over 8,000 companies, 8,036 to be exact. If you look at the next one on the list, the Vanguard Total Stock Market ETF, which is VTI, number of holdings is 3,861. And then we go down the list. You know, fidelity Global Monthly Income Fund has 1,926 companies and you can see the rest here, right? So they range from 560 companies to over 8,000. And to me, that is over diversification. That is a lot of companies that you own when you invest in these types of funds. So when it comes to mutual funds, index funds or ETFs, you need to investigate, you need to look deeper and see how many companies are these funds holding.

Speaker 1: 9:27

Now here's another one the Vanguard Growth ETF portfolio, the VGRO. This fund is interesting because, when you look at it, this ETF owns seven other ETFs, and so you can see the list up on the screen, right. So it owns the Vanguard US Total Market ETF. It owns the Vanguard FTSE Canadian All Cap ETF, and you know I'm not going to read the rest of them, but you can see them up on the screen here. So here you have an ETF which is a fund, an exchange traded fund, that owns seven other funds, and each of those funds own anywhere from 100 to thousands of companies, and each of those funds have fees the MER, the management expense ratio and we're not going to talk about fees in this episode. If anybody's interested, please go back and watch episode 38. And I talk more in detail in that episode about the negative impact of fees and MERs right, the management expense ratio. So any of these mutual funds, index funds or ETFs have fees.

Speaker 1: 10:35

But let's stick to our topic today, which is diversification. So you can see that the fund here up on the screen, the VGRO, the Vanguard Growth ETF portfolio, owns thousands and thousands of companies. So that brings us to our next topic. So then, what is wrong with too much diversification? So remember, our approach here is to invest in quality stocks when they're priced low. And how do we do that? We go through the 12 rules, and I just covered those at the beginning of this episode. We want to make sure that a company passes all the 12 rules before we invest in it.

Speaker 1: 11:16

Now think about this when you are buying a fund that owns, let's say, over 8000 companies or 5000 companies in that fund, what's going to happen is that when you're investing in thousands of stocks, you will virtually guarantee Okay, so let's move this over here. There we go. Investing in thousands of stocks will virtually guarantee that you end up buying stocks inadvertently that are overpriced. Okay, so that's one. You're going to end up buying stocks that have high debt. Right, remember rule number seven. We're looking at debt. Rule number 11 was to look at is the stock price low or high? You're going to inadvertently buy companies that are not recession proof, that are not profitable, that don't pay any dividends and there's lots of stocks out there that do not pay dividends. Basically, you're going to be buying stocks that are failing some or all of the 12 rules of simply investing. Does that make sense, like?

Speaker 1: 12:30

Think about this if you're investing in a fund that owns 5,000 companies, not all of those companies today are priced low. Some of them are overpriced and we don't want to buy those. If we wouldn't buy those individually, why would we buy them inside of an index fund or an ETF or a mutual fund? So that is where the problem comes to play when we are talking about too much diversification. You're essentially buying, so if you're buying an S&P 500, you're buying the top 500 companies in the US. If you're buying a North American index fund, then you're buying every stock in North America. I mean small pieces of it, but that's where your money is going. But not every stock in the stock market today is a quality stock. Not every stock in the stock market today is priced low and there are companies out there today that have a debt. They carry debt of 5,800, 900% and we do not want to buy those kinds of companies. So that's where you're going to get into problems and issues with investing in funds that have way too much diversification.

Speaker 1: 13:54

So now I want to share with you some words from George Anastasacos is the Professor of Finance at the Ben Graham Chair in Value Investing at the University of Western Ontario. Now I consider myself a dividend value investor because I'm investing in dividend stocks. When they're priced low, I'm looking at the value of the stock as well, not just buying, not just blindly buying any stock that pays a dividend. So I do consider myself a dividend value investor and a lot of my students do as well. So it's important to hear what Professor George is going to say about value investing. So he says, I quote value investors have concentrated portfolios, not because they reject diversification, but rather because they operate within the boundaries of their competence.

Speaker 1: 14:56

They select only securities or stocks that they understand. They prefer companies with stable cash flows and a history of steady earnings that can be reliably valued. So do you see what Professor George is saying here? We, as value investors, we are investing in concentrated portfolios. We are not interested in investing in funds that own thousands and thousands of stocks. So what he's saying here is focus on a few companies that are profitable, have a history of earnings, profitability, stable cash flow and are valued. You know, priced low. We call them undervalued. It doesn't mean they're bad companies, but for some reason or another, the stock prices come down and they're priced low.

Speaker 1: 15:56

If you want to know how to figure out when a stock is priced low or priced high, go back and take a look at episode one. I cover that in detail so you'll easily figure out. When you look at a company, is it priced low or is it priced high, and there's a link on the screen. I'll put that down in the description below. If you want some more detailed information About what professor George is talking about, go ahead and click on that link and you'll be able to see the complete article Posted up on my site.

Speaker 1: 16:27

I'm gonna share another quote. This is from John Keans, who is an economist, in 1930 and he wrote, I quote the right method in investment Is to put fairly large sums into enterprises which one thinks one knows something about. So, again, what he's saying here he's reinforcing what professor George was saying is to invest in what you know, and that's rule number one in our 12 rules of simply investing invest in what you know. The next article here Sorry, not article quote the next quote is from Gerald Loeb, who is a finance author. He wrote a book in 1935 called a battle for investment survival, and His quote I'm gonna read to you now. He says once you attain competence, diversification is undesirable. And again he's talking about building an investment portfolio. So if you know what you're doing, you don't need diversification. And I'm gonna leave you with one last quote, and this is from Warren Buffett, and he says, I quote Diversification is a protection against ignorance.

Speaker 1: 17:44

It makes very little sense for those who know what they're doing, and the 12 rules of simply investing are gonna help you to know what you're doing right. That's why I covered them at the beginning of this episode, so keep that in mind when you're starting to invest, or if you're already invested in either Stocks or mutual funds, or index funds or ETFs. So then you must be wondering does less diversification Really work? Well, let's take a look. So this is up on my website under a track record. You can see it on the simply investing comm website. This is showing the my portfolio, my, the stocks that I own since 1999 till the end at the beginning of 2022, okay, so From that period, you can see that my portfolio has gained over 543 percent Versus the stock market return of 317 percent. Now, what's even more important and you can see it highlighted on the screen here is that my stream of passive dividend income has Gone up every single year, and in fact, now it's been more than 22 years and has gone up every single year. So that's the focus.

Speaker 1: 19:06

The focus is not on the stock price, not on the value of the Portfolio, because the value goes up and down every day. The stock prices could drop tomorrow 10%. You know, we never know what's gonna happen in the stock market and that'll bring the value of the portfolio down. So the value changes daily and so I don't want you to get too concerned about that. The key is how much dividend income is your portfolio generating? Because it's those dividends, the cash that's coming into your pocket, that's what's gonna cover your living expenses and, at the end of the day, as investors, that's what we care about.

Speaker 1: 19:44

Okay, so then our last topic here is how much diversification do you really need? And the answer is quite simple on average, 25 to 50 high quality Dividend paying stocks. So that's an average you can have anywhere in between there. You can even have 55 stocks if you wanted to, but what I don't want you to do is to end up with investing in 300, 400, 500 stocks, because then You're no better off than the index funds and the ETFs and the mutual funds, and then you are Overdiversified.

Speaker 1: 20:22

And when you have that many number of stocks, not all of them are going to be quality stocks. Not all of them are going to be priced low today. So this is a good starting place. Start small, invest in small amounts in the beginning, especially if you're a beginner, and Keep track of the dividends that are coming in, and that's going to build your confidence over time that this approach works, and I've been doing it for over 22 years and teaching for over 22 years on how to become a successful dividend investor. So don't forget, our approach is to invest safely and reliably for the long term. Okay, so we invest in quality dividend stocks when they're priced low. And how do we know, when we're looking at a stock, if it's a quality stock and it's priced low?

Speaker 1: 21:13

Well, we use the 12 rules of simply investing. So I already covered these at the beginning of the episode, so I'm not going to cover them again. They're up on the screen. You can see the 12 rules For anyone that's interested. I cover the 12 rules in detail in the online Simply Investing course. It's a self-paced course. It's made up of 10 modules video modules so you just watch those.

Speaker 1: 21:39

Module number one I talk about the investing basics. Module two we'll go into the 12 rules in detail. Module three I'm going to look at applying the 12 rules to any stock anywhere in the world. I provide you with a Google Sheet, show you, step by step, how to get the financial numbers put them in. The Google Sheet will highlight for you which rules are being passed, which rules are being failed, and so you can see immediately whether a company is worth investing in or it's something that you should avoid.

Speaker 1: 22:11

The next module I show you how to use the investing Simply Investing platform, the module after that. I will take you step by step, if you've never done it before, on how to place your first stock order. The next module is looking at building and tracking your portfolio. The next module after that is learning when to sell. It's important to know when to buy. It's also important to know when to sell. The next module is reducing your fees and risk. After that, I will provide you with your action plan to get started. And the last module is answering your frequently asked questions.

Speaker 1: 22:48

For anyone that's interested, I've also built the Simply Investing platform. It took a little over two and a half years to build, and this platform automatically applies the rules to over 6,000 companies in the US and Canada every single day. So it's a web app. When you log into it, you can immediately see which companies to avoid and which ones to consider investing in. So if you're watching this or listening to this, you may want to write this down.

Speaker 1: 23:16

I'm offering a coupon code save10,. Save10,. Save10 is going to save you 10% off of all of our product and services. That includes the course the platform. The platform is a subscription, so every month, every year. As long as you remain an active subscriber, you will receive 10% off every single month or every single year. I also do one-on-one personal coaching, personal assessments, and you can save 10% off that as well. If you enjoyed today's episode, be sure to hit the subscribe button. We have new episodes out every week. Make sure to hit the like button as well, and for more information, take a look at my website, simplyinvestingcom. Thanks for watching.