“Diversification alone is never enough to protect you from all risks but it can shield you from one of the biggest risks we all face — our own ignorance.” - Ben Carlson
Michael Batnick recently came out with an article titled, My Friend is Beating Me. In the article, he tells the tale of two friends, one who has invested their funds in a diversified portfolio and the other who has all their funds invested solely into Facebook. The individual with Facebook as his portfolio is making more money than the individual with a diversified portfolio. The obvious next question is then, what’s the smarter move? Michael uses his financial wisdom to resolve the question (which can be found here) but I want to see if I can articulate a response to the question by simply using a little common sense.
I am a financial noob. I couldn’t explain to you what a CAPE ratio means or even how options work, but there are some things in finance that just make sense to me. Diversification happens to be one of those topics, not just because my fraternity happens to be ethnically diverse, but because I am a professional gambler.
Like a lot of fellow poker players, I used to get offended when one of my friends or members of my family (most notably my mother) would describe the game as “just gambling”. I’d spent thousands of hours learning probabilities, ranges, and tendencies all because I wanted to be the best, not because I wanted “to gamble”. But as I learned, regardless of how I would prefer to articulate it, every decision I made at the poker table was a gamble. When I get all my money in the pot preflop with pocket aces against my opponent's pocket kings I am only going to win 82% of the time. In other words, if we were to have this scenario play out 1000 times I would lose 180 of those pots. What I want to illustrate with this scenario is that regardless of the informed intelligence of any decision we make, at the end of the day, we are gambling.
But hold on a minute. If poker is just gambling, then how come they are professionals? Are these pros just luckier people than everyone else? While some are probably luckier than most, the entity that separates a pro from a recreational player is their ability to manage a bankroll. A bankroll to a poker player is the amount of funds he has access to, which makes its proper management so incredibly vital. I have lived my life according to this particular rule of thumb: you should never have more than 2% of your bankroll in play at any given time. And I’ll let Howard Marks, seasoned investor and writer, explain why.
“Here is part of the trade off with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off long term.”
We cannot control our fate, but we can optimize it. As poker players, we are going to experience spells of bad luck where we may lose aces to kings 3 times in a row and it sincerely feels like the world is conspiring against us. But if you manage your bankroll properly and have good, sound foundational strategy, you will ultimately end up a winner even if the short term feels hopeless.
Gambling is not confined to casinos. Webster defines gambling as, “take risky action in the hope of a desired result.” Whether we like it or not we are all gamblers. Every day we weigh the risk and reward of our decisions and everyday we gamble on them. I know it has become a cliche, but it is true that when we enter into a car we are gambling with our lives. We believe that the reward outweighs the risk and we proceed accordingly. This logic carries over to the markets verbatim.
There will be instances where a stock, like Facebook, can look a lot like pocket aces and you are tempted to move all in. However, we know that pocket aces do not always win, but folding and refusing to even play them would be letting our opponent win for free, even though we are the ones holding an advantage. So, the question becomes, how much are you willing to gamble on your stock pick? Well, what separates investors from gamblers is the same principle that distinguishes professional poker players from recreational players. Investors know that even though 80% of the time that stock will be a winner, the opportunity for calamity always exists. And for the same reason a poker player doesn’t play with all of his money at the table, an investor must only allocate enough funds he is willing to lose. And unsurprisingly, all the greatest investment minds tend to recommend allocating around 2% of your ‘bankroll’ into any given stock. These similarities aren’t random.
What I call bankroll management and Howard Marks calls diversification is the same thing. It is accounting for the unaccountable so that a winning strategy will ultimately win. Only time can tell if going all in on Facebook was a good move, but bad process leads to poor endings.