loader from loading.io

47 - Forced Diversification and Illiquid Stocks

The DIY Investing Podcast

Release Date: 10/20/2019

86 - The Tyranny of Backtesting: Why Backtests are harmful and counter-productive show art 86 - The Tyranny of Backtesting: Why Backtests are harmful and counter-productive

The DIY Investing Podcast

Investors use backtests in order to test whether a portfolio's asset allocation would have performed well in the past. The use of backtesting is harmful to a portfolio because it ignores uncertainty and overstates the value of empirical evidence.

info_outline
85 - Precisely Wrong, Roughly Right (DCFs) show art 85 - Precisely Wrong, Roughly Right (DCFs)

The DIY Investing Podcast

Discounted Cash Flow calculations and models provide precise estimates of intrinsic value but tend to be flawed. It is much better to improve accuracy by ignoring DCF and using a simple intrinsic value calculation like the Gordon Growth Model.

info_outline
84 - Would you buy your employer's stock? show art 84 - Would you buy your employer's stock?

The DIY Investing Podcast

The company you work for should be the first place you look to begin understanding how to perform scuttlebutt. Investors should analyze their employer's stock as a potential investment candidate. Culture, Quality, and Management are key areas.

info_outline
83 - Key Drawbacks of the Banking Industry show art 83 - Key Drawbacks of the Banking Industry

The DIY Investing Podcast

Banking is an industry with many key drawbacks including dependence on management for risk reduction, high leverage, low returns on equity, bankruptcy risk, and lack of pricing power because money is a commodity.

info_outline
82 - Why Banking is an Attractive Industry show art 82 - Why Banking is an Attractive Industry

The DIY Investing Podcast

Banking is an industry with characteristics that are quite attractive to long-term investors. Properly evaluated, a bank can make a great investment. High retention rates, lower competition over time, and the durability of the industry are what attract me to bank investing.

info_outline
81 - Always Ask Why: Bond Returns, Greater Fool Theory, and the 5 Why Framework show art 81 - Always Ask Why: Bond Returns, Greater Fool Theory, and the 5 Why Framework

The DIY Investing Podcast

Investors should always ask why when evaluating investments. This includes understanding the underlying reasons for their investing strategy, why they earn an excess return, and the edge of their circle of competence.

info_outline
80 - Zero Interest Rates should not reduce your Discount Rate show art 80 - Zero Interest Rates should not reduce your Discount Rate

The DIY Investing Podcast

When the Fed reduces interest rates to zero the first-order effect is a disincentive to save. Yet, zero interest rates should not reduce your discount rate because the second-order effect is because lower returns would increase your need to save money.

info_outline
79 - How Banks Make Money show art 79 - How Banks Make Money

The DIY Investing Podcast

Banking is a perfect example of a capital intensive business. A bank cannot grow unless it receives capital in the form of deposits. Deposits are the lifeblood of a bank and only through healthy deposit growth can a bank sustainably grow loans and therefore profits.

info_outline
78 - Earnings Yield on Cost: A valuation rule of thumb show art 78 - Earnings Yield on Cost: A valuation rule of thumb

The DIY Investing Podcast

Stocks must eventually trade at an earnings yield on cost equal to or greater than your discount rate in order to earn your required return on capital as an investor.

info_outline
77 - What is the source of your investment return? show art 77 - What is the source of your investment return?

The DIY Investing Podcast

Investing, as opposed to speculation or gambling, is a method of seeking returns while protecting our principal. You are not entitled to investment returns. So what is the source of your returns?

info_outline
 
More Episodes

Mental Models discussed in this podcast:

  • Liquidity
  • Diversification

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience. 

Follow me on Twitter and YouTube

Twitter Handle: @TreyHenninger

YouTube Channel: DIY Investing

Support the Podcast on Patreon

This is a podcast supported by listeners like you. If you’d like to support this podcast and help me to continue creating great investing content, please consider becoming a Patron at DIYInvesting.org/Patron.

You can find out more information by listening to episode 11 of this podcast.

Show Outline: Forced Diversification and Illiquid Stocks

The full show notes for this episode are available at https://www.diyinvesting.org/Episode47

Illiquid Stocks

  • Offer the chance for higher returns with lower risk
  • Less competition from professional investors

Forced Diversification

  • Can be caused by either:
    • Insufficient stock liquidity
    • Insufficient Conviction in High-Quality Ideas
  • Don't dilute your returns with low-quality ideas held in too large of a position size
  • My goal: Hold 5 stocks at 20% each. 
    • Currently, I am unable to achieve this goal because I do not have five ideas that are good enough to be worthy of a 20% position. 

Summary

Illiquid stocks offer substantial opportunity, but can also lead to an inability to purchase as many shares as you would like. This situation, along with a lack of good ideas, can lead you to rationally diversifying your portfolio more than intended. Cash has a high opportunity cost, so it is okay to build small positions in companies that are still high quality, but may not currently trade at wonderful prices. 

However, stick to your strategy and don't build full positions in companies if they do not meet both your quality and price standards.