Posted on by CTKS · 4 Comments

Change And Uncertainty

“The only constant in life is change.” – Heraclitus, Greek philosopher

The everchanging and unpredictable nature of markets is a going concern that stresses many investors out. Perhaps we have an innate desire for order and predictability, which explains why uncertainty and change make us uneasy. Whatever the reason, given that change and uncertainty is inextricably tied to investing, we investors can do better if we face the truth. In this article, I will share three main ideas pertaining to change and uncertainty.

1. Everything changes, embrace the idea of impermanence

For how much the world changes, it is unexpectedly difficult to visualise how quickly the world changes. A simple experiment borrowed from Warren Buffet illustrates this perfectly. Below is a list of the top 20 companies by market cap as of March 21st, how many companies do you think will remain in this list 30 years from now?

Surely Apple, Alphabet (Google) and Facebook will still be here, there is no other company like them!

Now, let’s take a look at the same list in 1989, 30 years ago…

You will see many familiar names on this list in 1989. However, what is striking is that none of these companies remain in today’s list. Zero. This goes to show how hard it is to predict the trajectory of businesses. This is not to say that it is impossible for the 20 largest companies today to remain on that list in 30 years time but whatever number we think it will be, chances are it is less. It is thus foolish to believe that certain things will NEVER change.

As investors, we need to be realistic and doing so will involve admitting that we cannot predict or be certain about the future. Instead, we should view the world through a probabilistic lens. Some companies have a higher probability of doing well and becoming successful, while others have a higher chance of failing. There is no such thing as a sure win. In fact, if anyone tells you that a company is sure to return you many times your money, take your money and walk away.

Looking at investing in terms of probability can help us make better decisions. As uncertainty cannot be completely eliminated, we should accept that there will always be a certain degree of risk in investing (i.e. there will always be a chance of failure). The goal is to find investments that has a high probability of working out and even if it does fail, the loss is marginal. In other words, a huge upside and limited downside. Therein lies the argument for having a certain degree of diversification. By having our eggs in different baskets, we significantly decrease the probability that our entire portfolio will go to zero. Even if the worst happens (the business fails due to low cost competitors or lawsuits or another recession hits), and it will, we can avoid crippling losses.

2. Even in an unpredictable world, certain things are surprisingly predictable

The future may be extremely unpredictable but history repeats itself. In the markets, cycles are surprisingly predictable. In the business and credit cycles, period of expansions are followed by periods of contraction. Likewise, in the stock market cycle, periods of euphoria are followed by periods of depression, which are then followed by periods of optimism again.

Thus, it is possible to study patterns in the past and use them as a rough guide for what could happen next. One such example is the stock market cycle.

As seen in the S&P500 chart above, a period of euphoria (from 1997 to 2000) is followed by one of despondency (2000 to 2002), which is then followed by another cycle of extreme optimism and greed (2002 to 2007) which is followed by severe pessimism (2008-2009). More recently, the Covid-19 pandemic resulted in a huge market sell off in March of 2020. Soon after, the markets rebounded to all time highs. Thus, it is inevitable that cycles will reverse and reckless excess will be punished, and vice versa. Therein lies a possibility of turning cyclicality to our advantage by behaving countercyclically.

However, this is not to say that we should start timing the market and enter at the bottom to sell at the top. After all, it will be foolish to think that we can predict when the tides will turn.

Since we cannot change the environment or predict it, we have to adapt to the prevailing climate by being more aggressive or defensive. Instead of thinking of whether to invest or not as a binary decision, we should see it in terms of a spectrum. When the market crashed in March of 2020, wise investors would have acted counter cyclically by deploying their cash reserves and picking up more shares in great businesses. At times like today when the markets seem to be approaching dangerous levels, we can perhaps hold back a little and start to accumulate some cash, waiting for opportunity to present itself. Some may even consider trimming their positions. However, I personally would never completely sell out of my holdings in expectation of profiting from a market crash. The expectation of successfully doing so is simply unrealistic in my opinion. As Warren Buffet puts it, “be fearful when others are greedy and greedy when others are fearful.”

3. First be lucky, then be humble

In being honest with ourselves about our limitations and vulnerabilities, we will come to appreciate the role of luck and risk in our lives and investing. Regardless of whether we like it or not, the two cousins play a role in every part of our lives and even more so when the markets are concerned. Where there is luck, there is also risk. From the lottery of birth to the successes in life, luck plays an elusive yet decisive role.

Thus, we should always remain humble and never get ahead of ourselves. We may make a series of successful investments/bets, but never take it for granted that our future endeavours will see the same success. As quickly as luck can bestow us with an obscene fortune, risk can take it all away.

It also follows that we should be grateful and contented with what we have. Do not succumb to greed and take riskier bets or taking on too much leverage such that when the unexpected happens, we will be in financial ruin and unable to climb back.

Exercise adequate scepticism and prudence in this uncertain world. Do not take anything for granted, be it that Apple will continue its dominance or that a company will continue its growth trajectory linearly. Yes, this may mean that we will miss out on some of the explosive returns we are witnessing in meme stocks today. However, it also means we are protecting ourselves from financial ruin and remaining in the game, making sure that we always have another chance for luck to be on our side. This is perhaps the only way to deal with luck and risk.

Posted on by CTKS · 2 Comments

Diversification – Wisdom Or Folly?

Diversification is perhaps one of the most highly contested topics amongst investors. Many super investors are of the opinion that diversification is the guaranteed road to being average. Warren Buffet once said “Diversification is a protection against ignorance… Makes very little sense for those who know what they’re doing.” However, there are many other world renowned investors that are in support of diversification. Even Benjamin Graham, Buffet’s mentor, advocates for diversification as a way to reduce portfolio risk. How can there be such contrasting viewpoints amongst a group of people with seemingly similar mindsets? In this article, I discuss the cases for and against diversification, some potential reasons behind the differing viewpoints, as well as my thoughts on diversification.

The case against diversification

Many investors such as Warren Buffet, Charlie Munger, Monish Pabrai and many more have very concentrated portfolios. The reason for doing so is to earn outsized returns and beat the market. The idea is very straightforward. In the entire stock market, there are some stocks that will lag the average and some that will lead the index by huge margins. The goal is to identify these businesses and concentrate your holdings in them. After all, if you were to diversify across hundred of stocks, you are better off just buying the index which saves on time, effort and costs. In his book, “The Dhando Investor”, Monish Pabrai encourages making few bets, big bets and infrequent bets, arguing that the results of those who place many bets, small bets and frequent bets are predictably pathetic. These investors walk the talk and have demonstrated their willingness to put a disproportionate amount of their portfolio in a few stocks. For instance, Buffet has been willing to put up to 40% of his portfolio in a single stock on certain occasions (Apple and American Express). As for Munger, his entire personal portfolio consists of just 5 holdings!

The logic here is surprisingly simple. If you are able to identify the few businesses that are going to do exceptionally well, it makes very little sense to invest in a bunch of other businesses for the sake of diversification.

However, it is important to note these investors still have a certain degree of diversification. This is a point that I will return to later on. For now, let us look at the case for diversification.

The case for diversification

Billionaire and hedge fund manager Ray Dalio, a proponent of diversification, famously created what he termed the “holy grail of investing”.

According to the holy grail, diversification can reduce risk without hurting your returns. Furthermore, the lower the correlation between the asset class, the better the effect of diversification (with uncorrelated assets giving the best effect). Ray Dalio recommends investors to find 15-20 uncorrelated streams that will allow for the most return on investment while cutting risks. Ray Dalio also recommends diversifying across asset classes, sectors, currencies, countries, and investment “styles” (like small cap, growth, etc., in equity markets).

Sir John Templeton, who’s fund averaged annual returns of 15% for 38 years, also advocates for broad diversification to guard against our own fallibility. He tells investors to expect a third of their investments to go south. In essence, these investors recognise that not everything in this world can be known. Thus, they argue that diversification is the key to build a resilient portfolio as it guards against the unknown unknowns.

Diversification exists on a spectrum

It is important to note that diversification exists on a spectrum. On one end, we can have a portfolio consisting of only one stock and on the other, we can buy the entire stock market. Additionally, risk and returns can also be placed along a similar spectrum.

Different definition of risk

The first possible explanation for the contrasting opinions on diversification could be the different definition of risk that these investors believe in. There are two main school of thoughts here. Those who favour concentrated portfolios belong to the camp that believes that risk is the probability of permanent loss in capital, while the advocates of diversification are likely to measure risk as the volatility of the portfolio (i.e. the chance of suffering a loss in a given time period). This begs the question, which definition is right? I believe that investing is a craft, not a science. Thus, there is no universally correct definition, only what is right for you. If you are like Warren Buffet or Charlie Munger who possess the ability to tune out the market noise and ignore volatility without losing sleep, risk is perhaps better defined as the probability of permanent capital loss for you. In this case, holding only a handful of businesses that you thoroughly understand can be justified. However, if you find yourself fretting over the daily ups and downs of the stock market and at risk of acting on impulse and based on your emotions, volatility is the better definition of risk for you. This is because volatility increases the risk of you acting on impulse and making a mistake (selling at the bottom or buying at the peak). In this case, it will likely be prudent to reduce volatility by diversifying broadly. Of course, this means that you may be subjecting yourself to lower potential returns, bringing me to the next point on personal goals.

Varying aims

Investors such as Buffet and Monish Pabrai pride themselves on achieving high returns in excess of the market average. Many shareholders put their money with these investors in hopes earning market beating returns. For these investors, it makes perfect sense to concentrate their portfolio in a few holdings that they believe can deliver higher returns than the market in order to maximise returns for their shareholders. On the other hand, Ray Dalio is a hedge fund manager and has structured his fund around delivering decent returns with minimal volatility. It is worth noting that investors in his fund include many pension funds. Thus, countless people rely on his fund’s returns no matter whether the stock market is up or down in a particular year. It’s money that they cannot afford to lose. In this case, diversification across a broad range of asset classes and industries with minimum correlation is the means to smoothen the ride for their shareholders without compromising on returns. Hence, the duty to shareholders also influences their strategy. In other words, the difference in their degree of diversification arises from what the investor seeks to achieve.

Conclusion: diversification for the retail investor

Unlike fund managers, we retail investors do not have to answer to shareholders. The only person we are answerable to is ourselves (and our family). This means that we are free to structure our funds according to our own definition of risk and personal goals.

If you do not have the temperament to watch your portfolio tank 40% or more during a recession without losing sleep and/or you are contented with average or slightly above average market returns, the view that the definition of risk is volatility may be most suited for you. In that case, seek to reduce the volatility of your portfolio by diversifying across various asset classes (bonds, commodities, stocks), industries and geographies. For starters, check out my article on an adaptation of the three fund portfolio to the Singapore context.

If your goal is to compound your money at upwards of 15% per year and you can stomach volatility without losing sleep, you can consider adopting the view that risk is best defined as the probability of permanent capital loss. As long as you invest in sound businesses that continue to grow, the stock price will eventually converge on intrinsic value and volatility is merely noise. However, super investors such as Buffet and Munger possess a unique ability to analyse businesses and much more resources to gather information not available to the layman. We should be humble and recognise that we cannot be a 100% sure about any investment. Hence, I believe the ideal diversification (based on the definition that risk is the chance of permanent loss, not volatility) lies somewhere in between the concentrated portfolios of super investors and buying the entire index. My personal preference is to have 10 to 15 stocks, with no more than 10% of my portfolio in a single holding.

In fact, there is nothing that is stopping us from doing both. We can allocate a sizeable chunk of our portfolio to index tracking ETFs (for instance 50-80%, depending on our preferences) and have the rest in a handful of businesses that we believe are undervalued. This portfolio may not achieve returns in excess of 20% but it can still deliver slightly better than average returns, as proven by Ray Dalio and Sir Templeton, who both edged out the market over extremely long periods of time while maintaining a high degree of diversification.

What matters then is to choose a strategy that is aligned with your personal goals and temperament. This way, we will be able to stay the course even in difficult times that test our faith.

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