Co-authored by Treading Softly
At my home, it is always an exciting time when someone gets to collect the chicken eggs from our coop. Our flock of chickens has always been highly productive, meaning that we get a large number of eggs every single day from our hens.
My children loved to go collect those eggs. I remember a time when I watched a one-year-old stumbling across the backyard with an arm full of eggs. They tripped and fell and smashed the entire armful into their chest. Let's just say there were no eggs gathered that day successfully.
This is the crux of the saying to not put all your eggs into one basket (or one child!). If you put all of your eggs into one basket, you may lose them all at the slightest stumble. While most of us are not going to be a toddler running across a muddy backyard in rain boots basking in pure enjoyment and excitement over having collected what to many would be a very insignificant commodity, instead, we are adults investing in the market with our life savings trying to ensure that this nest egg can support us through our future endeavors and our retirement. I would dare say that our basket is holding a much more precious commodity to most of us.
What amazes me is that while many will say that they don't want to put all their eggs in one basket, many investors will likewise scoff at the idea of a large number of portfolio holdings. There has got to be a middle ground between holding so few that a single investment failure will destroy your retirement, and holding so many that it's unmanageable. This is where I have taken time to develop a key component of my Income Method. For those of you who are not acquainted, my Income Method is my philosophical approach to how I look at not only the market but also investing and how I interact with money. You don't have to go far to discover that everyone has an opinion on how money should be spent or managed. Some people will live in a laissez-faire mindset, while others will be penny-pinching scrooges who will refuse to donate even to the noblest of causes because they don't want to lose a single coin. Like much in life, the middle ground often ends up being the best, so today, we're going to take a moment to look into one of the pivotal rules within my unique Income Method. We'll discuss why it is that way and how it can benefit you.
Let's dive in!
The Rule of 42
In The Hitchhiker's Guide to the Galaxy by Douglas Adams, an alien race is desperate to find the answer to life, the universe, and everything. So what they do is that they design a massive supercomputer called Deep Thought that takes millions of years to determine what the answer is. When Deep Thought has come up with the answer, this alien race assembles to discover what the answer is. The answer is simple and sweet. The answer is 42.
When I developed the Income Method many years ago, I knew diversification was exceptionally important. It still is.
We can see from the chart above that as you add additional securities to your portfolio, the concentration risk of having a small number of portfolio holdings decreases. Eventually, we reach a point where if you have 50 holdings, it would take an additional 50 to reach 100 before you see any real further reduction in your portfolio's risk. However, between 30 and 50, sitting right there around 42, we hit this sweet spot where we've now enabled our portfolio to no longer suffer significant risk from any individual holding. You're always going to have the risk of the entire market. Market-wide risk is unavoidable as long as you're invested in it.
By investing in a larger number of holdings, you can reduce the impact that any individual holding can have on your portfolio. This reduction means that if one portfolio holding is massively outperforming, it's not going to benefit your portfolio as much. But likewise, if the unimaginable happens and that company completely shuts down and disappears, it's not going to tank your portfolio.
When asked what size holding I'd be willing to have, I like to reference what I call my "FBI test." I tell them that if they woke up tomorrow and found out that the FBI had raided the headquarters of the company and the entire company was fraudulent, how much would they be willing to completely lose on that investment? They should never invest a dollar more than that.
A portfolio having 42 unique holdings, will have on average, a 2.4% exposure from any single investment. I also include CEFs and ETFs as single investments because you are investing under the oversight of a single manager. Just like I don't treat a BDC as a bunch of investments in different loans, I likewise don't treat a CEF as a whole bunch of different investments from my diversification viewpoint. By reducing the amount of risk that each holding presents to my portfolio, I'm able to divide my eggs among more baskets. Instead of having one toddler running across a muddy field, I have 42 toddlers running across the muddy field. The likelihood of getting eggs to my front door from the chicken coop exponentially increases. There is always that general risk that all of those toddlers might fall if the wind blows too hard or if the field is too muddy, but the likelihood that some are going to make it to me unscathed is much greater than if I trust just one toddler.
More Dollars From More Places
By holding 42 different investments in your portfolio, you're able to see more income from different sources. This enables you to have a lower risk from each individual holding, but a costly mistake that many novice investors make is simply trying to hold 42 different investments without also considering where those investments are located within the market. It is important to also maintain a healthy level of sector diversity. You're going to want some BDCs, some energy holdings, some utilities, consumer goods, and the list goes on. The Rule of 42 allows you to have an easy goal post to have specific individual security diversification. You also must keep in mind that there are additional layers of allocation guidelines that should exist within your portfolio. This is something that we provide members of our private investing community: an easy tool to help them see three different layers of diversification. Diversification of individual holdings, diversification across sectors, and between fixed income and equities - allowing them to be able to step back and get a holistic picture of their portfolio.
The goal when it comes to your retirement should be that you have income pouring in from multiple different sources. You don't need hundreds of holdings in your portfolio to be able to achieve healthy levels of diversification. If you spend two minutes every three months reviewing each one of your 42 holdings, you will spend only 84 minutes - just under an hour and a half every three months when earnings come out. That's not very long at all, to ensure that your portfolio is running healthily and can provide you with stable, steady, and increasing income throughout your retirement. The end-game goal of my unique Income Method is to enable as many people as possible to have a successful retirement living in financial security. One of the key rules within my unique Income Method is the Rule of 42 - holding at least 42 income-generating investments that enable you to have reduced risk from any individual holding.
Whenever somebody asks you, "Isn't that holding too risky?" The answer may be "For you, yes." Within proper allocation guidelines, any portfolio holding has the potential not to be too risky if it's fundamentally secure and it is simply seeing share price movements due to market sentiment.
That's the beauty of my Income Method. That's the beauty of income investing.
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