Diversification vs. concentration

[TomPie]

I would like to hear your thoughts/ what’s your approach.

As an example - I have a portfolio of rental properties. Around 70% of my Net worth is in these rentals. Paper assets (index funds) are ~ 15%, rest is in cash. Obviously the rentals represent a concentrated risk (little regional diversification, relatively few rentals, leverage etc.) That said, they earn significantly more than paper assets.

What is your approach? Are you ok with concentrated bets (eg stock picking, your business, rentals) because (you think?) you know what you are doing and you can get significantly higher ROE or do you try to diversify as much as possible across investment types and even within these investment types? As an example - 1/3 in rentals (various cities/ types of rentals); 1/3 in business and 1/3 in paper assets (globaly diversified).

Thanks

[2Birds1Stone]

I'm simple. 55% of networth in domestic and international stocks, 10% in bonds, 5% precious metals, 30% cash and cash equivalents.

[wolf]

My approach is to diversify. Ideally I'll have several non-correlating assets, e.g. real estate (where I live in and/or rented), cash, equity, bonds, pension, "career capital" (work income), etc. Therefore I'm not ok with (large) "concentrated bets", because I don't think that I can outthink/beat "competitors" in those markets. In very small amounts I try to do concentrated bets, e.g. I have some few thousands invested in commodities, where I try to time the market with an active investment style. Currently (I'm still working towards FI), I favour diversification over concentration.

How much do you understand/know the rental property market? Are you better than average? If so, why do you want to change?

[Seppia]

My situation is:

1- 85%+ of my yearly income comes from my salary.

2- In terms of investment assets, I have mostly stocks (60% individual stocks, mostly european, 40% indexes), plus a growing cash allocation (today at around 16-17%) and that's it.

3- I also own new, paid off small (550sqf approx) apartment in my hometown + I have some semi SHTF tradeable skills (I could be a professional cook in a mid-high level Italian trattoria).

1- is my cash machine, which I plan to let running for a few more years
2- is my ERE stash/FU money/however you want to call it
3- is my semi-SHTF security blanket

In the future, my plan is to expand 3- by adding some food growing skills, and (maybe later on) add some 4- real SHTF security blanket skills (gun shooting/repair/maintenance).

So I would guess it also depends on what you mean by concentration/diversification.
From a purely financial planning perspective I am quite concentrated, but I personally think the useful kind of diversification is the diversification that helps you mitigate what I may define as "scenario risk".

Not sure I'm making any sense

[ThisDinosaur]

I personally think the useful kind of diversification is the diversification that helps you mitigate what I may define as "scenario risk".

This is how I think about diversification, too. (1)What could happen? (2)What can I do now to prepare for that?

I was reading an interview of Peter Thiel recently where he says diversification is for people without conviction. "Spray and Pray." He's probably right. But there's always those unknowns unknowns to watch out for. I'm prepared for both ways of thinking to be correct over different timespans.

[Lillailler]

I am a keen diversifier. Let's imagine you have reached your 250k, 500k, 1m or whatever you need for a 2.5% SWR to sustain financial independence indefinitely. If your investments go up 50%, that is good. You can either spend a little more during your lifetime or leave more to your heirs and charities of your choice. It is not however, life-changing. You are still financially independent, but now with extra security in terms of a bigger buffer against adversity. On the other hand, if your investments go down 50%, then you are going to have to go back to work, and likely in an adverse situation: skills, qualifications and experience, and industry contacts all well out of date. Your life has indeed changed. It therefore makes sense to me to put more emphasis on defending against big losses than chasing big wins when it comes to portfolio management. To me diversification is one of the ways to avoid, or rather reduce, the possibility of a big loss. In engineering terms, it's about removing single points of failure, and it absolutely does happen that people get hammered by points of failure.

Some illustrations:
I remember Rolls Royce going bankrupt in 1971. Many workers had been encouraged to buy shares in the company, so that on the same day they lost their savings and their jobs. Thirty years later a similar thing happened to many Enron employees. In 2008 an acquaintance of an acquaintance, who was a long-term employee of RBS and who had saved up decades of bonuses in RBS shares, lost around a million pounds more or less overnight. Accordingly, I make sure that no single company represents a large percentage of my portfolio. Of course this reduces the prospect of big gains by investing in 'winners', but as I explained above in my view the effects of losses versus winnings are asymmetric.

If you don't fancy the odds of picking your own diversified portfolio of shares, spread across industry sectors, geographical sectors and countries of registration, maybe it makes sense to contract the job out to an investment management company. Just don't put more than you can afford to lose with a Ponzi scam artist. But, you say, <fill in name> is no scammer, he / it is a highly respected figure or famous old institution, or well-known rising star. Reflect that all successful scam artists are highly respected right up to the point they are found out, by which time it is too late to save yourself. And of course, even long-lived respectable institutions can be brought down by a rogue insider - check out the stories of Nick Leeson and Jérôme Kerviel. Accordingly, I use more than one broker, investment manager, ETF provider etc.

Sometimes banks go bust, too. Look up the stories of the bank crises in 2008 (UK, Iceland), 2013 Cyprus, 2015 Greece. Some account-holders were not affected at all, others lost some of their money, some had to wait days, weeks or months to get access to their money again. Obviously it is a mistake to deposit money with a bank which is going to go bust, but usually by the time you find out that your bank is going bust, it is too late. Consequently, I have diversified banking arrangements - more than one bank in more than one country.

Maybe this is paranoia, but I feel more comfortable this way

[wolf]

+1 to Lillailler

[TomPie]

Ok, maybe one more comment. You raised some good points around diversification - related to paper investments (shares/ bonds).

What I was (more) talking about is diversification across asset types - to simplify I distinguish three categories: paper assets; real estate and business (and maybe work, but that isn't very passive).

From what I read above some of you are highly concentrated in paper assets (most of your assets are in this one category only). So from this perspective you are concentrated too. I'm concentrated in real estate and I'm fine with it, since I (think) I know what I'm doing. You are obviously fine with your allocation since you (think;) you know what you're doing.

Hope this makes more sense.

[marcdemar]

My portfolio currently consists of 85% real estate (my mortgage-free home), 14% stock (very concentrated, it's shares in the company I work for), 1% P2P.

I like to look at it in this way:
1) xx % of my portfolio needs to be low volatility/risk.
2) xx % higher volatility, higher risk. This is the growth-corner of my portfolio
3) xx % alternative/experimenting. See what happens and whether I can build some income streams from that

Currently, 85% is real estate. That's too much and I am expanding both 2) and 3)

2) Is very concentrated and only consists of shares in the company I work for. As an employee I can get them for a discounted price and it would be stupid not to allocate the majority of my investments to this (current discount is 50-60%). The question is whether I should sell off at least part of the shares and invest elsewhere to mitigate the risks associated with this 'single point of failure'. This is entirely a question about risk tolerance. I will probably sell off once I have figured out all the tax implications.

3) I want to expand in the crowdlending and crowdfunding asset classes.

Now, as I get closer to early retirement, the composition will probably change. I will choose a more defensive portfolio. More real estate, maybe bonds, etc.

[Campitor]

Take this with a grain of salt. Diversification is always good. If a sector experiences a downturn, such as real estate, you have other investments that could potentially offset any losses. However, it has been advised that it's best to stick with what you know. If you have a deep understanding of real estate, it will allow you to take advantage of opportunities that a depressed real estate market may have. You can buy more property at devalued prices that allows you to rent out more units, at a lower price, which offsets any loss in income. But you have to be real good at what you do and have the money to execute. Understanding is one thing and being able to spot and have the resources to exploit an opportunity is another.

[arcyallen]

TomPie, I'd consider what those categories mean. Paper, Real Estate, and Business. Really, "Paper" is really just a representation of those other two. You can own REITs, which are ultimately owning real estate. You can own stock, which is ultimately owning a piece of a business. I think when you own the hard investments directly you have greater control, at the cost of greater effort. I owned my own business for six years, and I can tell you my stocks never called in sick I own a homebuilding stock (DHI), but I have no interest in the headaches of building and selling houses myself.

[Lucky C]

1. Reduce expenses: Currently working on home renovations that have an almost guaranteed > 10% return (insulation and other energy improvements). Reducing expenses is always better than hoping investments cover a higher level of expenses.
2. Diversify "work" income streams or the ability/willingness to work diverse jobs as needed: engineering, food services, childcare, handyman/repair...
3. Investment strategy that seeks low drawdowns (but not necessarily maximizing diversification or minimizing volatility)

Altogether I would say this is a very diversified approach without just relying on the past performance of a very diverse portfolio (e.g. Merriman Ultimate).

Concentration seems very anti-ERE. For extreme examples see /r/wallstreetbets

[suomalainen]

From what I read above some of you are highly concentrated in paper assets (most of your assets are in this one category only).

Meh. Legal form over substance. You don't "own" real estate either. You own a piece of paper that allows you to go to a judge to say "give me an order that says that guy over there can't do X on my property." That piece of paper defines what "your property" is. Without the paper and without the judge (i.e., rule of law), property (whether real or personal) rights don't exist.

Also remember that the only way real estate becomes productive is (i) if you farm it or (ii) you get someone to sign a piece of paper agreeing to give you money (rental or sales contract). It doesn't sound like you're a farmer.

It's paper all the way down.

[7Wannabe5]

@suomalainen:

You can use some degree of physical force to defend real property you own and currently hold. OTOH, if you store your rare book inventory in warehouse controlled by J.Bozo, then you are the one who would have to hire a lawyer to get them back.

If you want to change your life, don't be tempted to outsource your life or your operations. You'll never know which kind of connections or synergies you're missing and you'll only make yourself more dependent on your suppliers. - ERE-the book

[Jason]

If you are talking replacement cost of primary residence, it's ultimate value is really the insurance policy that covers it. And that excludes "acts of God" which I find ironic being that those Warren Buffet motherfuckers are most likely committed atheists until it costs them money but in any event, that makes the physical value even more tenuous. It's not like your house in its component parts is going to get your money back. And market value is, of course, fluid, just like a financial instrument. Now, if it an investment property, it could be worth more based on the NOI and the rate of return that people are willing to base the sales price. But being that's market conditions and well, that's paper too. So I think Suo makes a good point.

Some (most?) states require a deed when a sale is consummated (I know Manhattan doesn't). Once, again paper. So ultimately, pointing to your house saying I own it doesn't get you that far in protecting it as an asset in its various and multiform ways.

[7Wannabe5]

So ultimately, pointing to your house saying I own it doesn't get you that far in protecting it as an asset in its various and multiform ways.

True, but you can put out a small fire before it gets worse in your own kitchen. Sometimes you can have ownership without dominion, and sometimes you can have dominion without ownership, and sometimes you have both. Even eminent domain does not negate the reality of actual domain in the moment. It is structurally impossible to have domain over 1/10 millionth share of Amazon-you are just a droplet in the wave. It is very possible to have domain over your small business or backyard garden. IOW, scale and proximity do matter.

[Jason]

I understand. But I think most people would make the case that the kitchen that I have 1/10 millionth share is more secure than the one in my domain.

[7Wannabe5]

@Jason-Gotcha. Let me rephrase. If a mathematician wrote a paper which proved that no man can possibly f*ck his wife any better than a monkey with a dart, would you put your wife on a train to join J.Bozo's harem, because on paper she would still be your wife, and J.Bozo is an undoubtedly an incredibly efficient f*cker?

[suomalainen]

@Jason-Gotcha. Let me rephrase. If a mathematician wrote a paper which proved that no man can possibly f*ck his wife any better than a monkey with a dart, would you put your wife on a train to join J.Bozo's harem, because on paper she would still be your wife, and J.Bozo is an undoubtedly an incredibly efficient f*cker?

What. The. Hell??

[Jason]

Do you think we should send that to the FBI?