NOTE: this was a past issue of my weekly newsletter, Timeless Gems. Join my free mailing list so you don’t miss out on future issues.
Today’s gem is this framework for diversification by John Huber of Saber Capital:
There are all sorts of frameworks for diversification out there, but this one is by far my favourite.
When we think about managing risk, we think about financial risk, business risk, industry risk, etc… but we seldom consider “emotional risk”. But emotional risk is something that should be actively managed as well.
Let’s take the extreme – imagine you invested your entire net worth or portfolio in a single business (such is the case for many entrepreneurs). You would immediately start forming biases, it’s just human nature. You would view that business/industry in a very positive light, and in fact, you might start to tie your identity to it. But short-term negative events might also cause serious adverse psychological harm, and cause you to make irrational decisions. Ask any entrepreneur how much of an emotional rollercoaster it is!
Side note: an entrepreneur’s job is to build a business, not manage investment risk & returns, I was just illustrating an extreme investor example.
So, using John’s framework, you want just enough diversification in your portfolio that you’re unemotional about any individual investment. This will enable you to act rationally in making investment decisions and minimize biases. Just enough is a key component here because too many investments and you start to harm your returns. The right number is subjective and unique to each investor.
Diversification is a balancing act between managing risk (including emotional risk) and generating above-average returns.
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Source to the full article can be found here. John is perhaps one of the clearest thinkers in the investment business. I’ve spent hours reading his writings, he articulates original thoughts and timeless concepts. Highly recommend subscribing to his blog.
