Elon Musk is one of the best brilliant minds alive today.
He has built three revolutionary companies in completely different fields – Paypal (Financial Services), Tesla Motors (Automotive) and SpaceX (Aerospace). He been responsible for several technical innovations that many thought impossible.
Musk says these innovations are made possible by “Reasoning from First Principles”.
Err! What in the world does that mean?
And by the way, what does it have to do with investing?
First Principles Thinking
Let us hear it from Elon himself..
“Well, I do think there’s a good framework for thinking. It is physics. You know, the sort of first principles reasoning. What I mean by that is, boil things down to their fundamental truths and reason up from there, as opposed to reasoning by analogy.
Through most of our life, we get through life by reasoning by analogy, which essentially means copying what other people do with slight variations.“
Let us see, how Elon puts this thinking framework into action.
In 2002, Musk began his quest to send the first rocket to Mars. But he had a problem. After visiting a number of aerospace manufacturers around the world, he found that the cost of purchasing a rocket was way too high.
He began to approach the problem using the first principles approach.
“So I said, okay, let’s look at the first principles. What is a rocket made of? Aerospace-grade aluminum alloys, plus some titanium, copper, and carbon fiber. Then I asked, what is the value of those materials on the commodity market? It turned out that the materials cost of a rocket was around 2 percent of the typical price“, Musk said in an interview.
So, instead of buying a finished rocket for several million dollars, his company directly purchased the raw materials and built their own rockets at far lower cost.
As seen above, First Principles Thinking is the act of deconstructing a process down to the fundamental parts that you know are true and building up from there.
This can be implemented using three steps
- Identify and define your current assumptions
- Breakdown the problem into its fundamental principles
- Create new solutions from scratch
Let’s discuss how you can utilize first principles thinking in your investing.
How to build an equity mutual fund portfolio?
1.Identify and define your current assumptions
We need to diversify. Let us add several equity funds so that even if one fund is not doing well we don’t get impacted to a large extent. The lesser the number of funds the more riskier it is. We need to constantly be in search of the next best fund to add to our portfolios.
2.Breakdown the problem into its fundamental principles
Fundamentally, when we say we are building our equity portfolio, we are actually buying stocks (part ownership across several businesses).
If we are picking stocks, our long term intent is to outperform the benchmark by a comfortable margin. Else we could have simply put our money in an index fund and relaxed.
If we just pick one business, then we risk our entire money if something goes wrong with the business and stock price tanks. So we need to diversify across several stocks – across size, sectors, styles and geographies.
But again diversification has a flip side. Just like how it protects and limits the impact of a single stock tanking, it also limits your potential upside. Say one of your stocks jumps 100% (but it’s only 1% of your portfolio), it won’t take your portfolio up that much.
This is a tradeoff that we will have to carefully consider.
So the question is:
How many stocks are needed for adequate diversification?
In their book Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown reported that “…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.”
Burton Malkiel, author of A Random Walk Down Wall Street, explains:
By the time the portfolio contains close to 20 [similarly weighted] and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.
The father of value investing, Benjamin Graham in the fifth chapter of The Intelligent Investor explains
There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
Seth Klarman in his book Margin of Safety explains..
Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbable events can best be mitigated through prudent diversification.
The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice.
Both academics and well known investors, mostly seem to agree that adequate diversification can be achieved from around 20-30 stocks.
Now most of this is based on some academic research or popular global investors for whom this has worked.
How do we know if this holds true in India?
Almost every equity diversified mutual fund, has the mandate of outperforming their benchmark indices over the long run.
Majority of the funds have portfolios in the range of 20-70 stocks. There is not a single mutual fund which has above 100 stocks.
This simply means that, all fund managers believe that it is extremely difficult to beat the benchmark with a large no of stocks (say more than 100 stocks).
Also look at the PMS industry. Their intent is to provide higher return products compared to mutual funds. Most of them run extremely concentrated portfolios with 10-30 stocks.
Again this is telling us something. The PMS industry sees concentration of stocks as a key ingredient to produce out performance.
Both the MF and PMS industry has an important message for us..
If we need to improve the odds of our equity portfolio beating the benchmark index, it is clear that we can’t have too many stocks (say more than 100).
Now unfortunately when we add mutual funds to our portfolios we forget that we are adding around 40-70 stocks each and every time. We forget that the each fund manager is already reasonably diversified across stocks in his individual fund.
Most of us, confusing diversification of stocks with diversification of funds, end up having too many funds, which implies underlying portfolio of several stocks with insignificant allocations.
In essence, we end up creating a expensive version of a Nifty 500 index fund.
3.Create new solutions from scratch
Simple. Since every diversified equity fund already provides diversification across stocks, the key is to actually concentrate when it comes to funds.
To start with put some simple rules:
- Not more than 4 equity funds to build an equity portfolio (I know this might make you extremely uncomfortable. But remember – you are finally taking exposure to stocks and not funds)
- Check if 80% of your equity portfolio is represented by less than 100 stocks. Else, you are over diversified.
- Less than 15 fund recommendations for the next 5 years from your Advisor*
If you are advised by an advisor, keep a limit of 15 fund recommendations for the next 5 years. Provide him a simple 15 slot punch card, and every time you have a new idea being recommended, one slot will be punched.
Under these rules, both you and your advisor will be forced to think carefully about what is recommended. This will help you keep your sanity amidst a barrage of new flavor of the season products which get launched every month. This will also address the mindless churn of mutual funds as and when the investment style goes out of favor.
Ideally the best case should be to stick to 4 funds with minimal churn. But since usually there will be some issues like – change in the fund manager, style drift, performance concerns (with the right context) etc we might need to exit and add new funds.
*(This is inspired from Warren Buffet’s 20 slot ticket idea)
Every time I meet a new investor, almost inevitably I see at least 10-20 funds. Add to it the fact that they have 2-3 advisors multiplying this effect.
While all the other areas of investing get enough attention, somehow the topic of over diversification hardly gets the required attention despite its importance.
I hope that my readers would start taking notice of the unintended over diversification which happens over the years to their portfolios and take some time out to simplify their portfolios.
Remember, when it comes to number of funds – lesser the better!
As always Happy Investing 🙂
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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.