Overview
One of the oldest debates in the investing community is that of portfolio diversification, specifically the question of whether diversification is a prudent move or not.
I wrote about investment diversification and concentration in a previous article, and I encourage you to read it if you haven’t already.
Lots of investors know about or at least have heard of diversification, but probably do not give it enough serious thought. It’s easy to say, “diversify your portfolio”, but words are cheap. A specific diversification strategy must be followed – diversifying just for the sake of saying “I have a diversified portfolio” is not effective at all.
My take on it is this:
Diversification is important, yes, but I believe it should be carried out on a “just enough” basis. That is, holding other investments to offset the risks posed by others. If an investment poses a high risk in certain categories, I will look for another investment that do not face the same risks.
Since I do not want to spread myself thin in terms of both capital and my attention to each investment, I will perform only the minimal amount of diversification necessary. A concentrated portfolio does not pose significant investment risk if you monitor it like a hawk.
Let’s first understand what the different types of risk are.
The Different Types of Risk
In the Investment Risk – an Engineering Perspective article, I discussed at length what investment risk is, and a tool investors can use to estimate that risk.
While investment risk is something I believe can be approximated and mitigated, there are other risks investors cannot accurately ascertain. In Corporate Finance for Dummies, author Michael Taillard goes over the following risk categories:
- Interest Rate/Inflation Risk: The risk that interest rates or inflation will outpace your returns
- Market Risk: The risk that the entire economy might do poorly
- Credit Risk: the risk that a borrower won’t repay their loan
- Off-Balance Sheet Risk: The risk that something not included on the balance sheet is influencing corporate value (e.g. unrealized gains, derivative losses)
- Foreign Exchange Risk: The risk of losing value through fluctuations in foreign exchange rates
- Operating Risk: Risks associated with corporate operations
- Liquidity Risk: The risk of not having enough money on hand when bills become due
Since the book is introductory in nature, I’m sure there are many more risk categories in existence. I do not intend to list every risk that an enterprise will face, that is not my goal here. This list goes to show the types of risk most enterprises face and must constantly deal with.
It may be tempting to try and quantify these risks down to a single number, but as I discussed in the Investment Risk article, risk is a lot like intrinsic value; that is, it is a measure that can be approximated, but cannot be arrived at precisely. Risk is more of a perception than a neatly quantifiable variable.
Every publicly traded enterprise is exposed to myriad risks, many of them far beyond their control. Banks cannot dictate federal interest rates, and oil & gas companies cannot control the price of oil or natural gas.
As mentioned earlier, my approach to diversification is to offset the risks posed by one enterprise by holding another that is not exposed to the same risks. The risks faced by TD are different from the risks faced by Enbridge, but both, in my view, are strong businesses.
Now, this logic of holding different enterprises to offset risks may lead to the following line of thinking: if holding more companies lowers risk, why not just hold as many companies as possible?
That is a fair question, and many investors opt to do this by purchasing index funds. Theoretically, index funds pose very little risk because you essentially have a small slice of the entire market.
A logical approach, yes, but I did not spend several years studying investing just to end up buy index funds.
I have unwavering confidence in my ability to analyze securities, and I firmly believe that by the time I make an investment decision, I will have performed such a thorough analysis that I have an excellent understanding of all the risks an enterprise faces. In my view, there is an inverse relationship between the need to diversify and one’s understanding of an investment operation.
Diversification Cannot Replace Thorough Analysis
Again, while I do believe diversification is important, I see it as something that needs to be done solely out of necessity.
Different companies are in my securities portfolio not because I want to hold lots of enterprises, but because each enterprise poses specific risks that I cannot all control. In a perfect world, I would place all my eggs into one basket.
Warren Buffett once said that diversification is protection against ignorance, and that diversifying makes little sense if you know what you are doing. I wholeheartedly agree. The need to diversify goes down dramatically if every investment in your portfolio has been painstakingly analyzed and thoroughly understood. An operation with very high investment risk and considerable risk in other categories should not be in your portfolio in the first place.
Mr. Buffett is also known for advocating the 20-slot rule; imagine an investor can only make 20 investment decisions throughout their entire lives. There is very little room for error, so this forces investors to ensure they know nearly everything about a prospective investment operation before committing any money.
By limiting the number of investments made, the hope is only the most informed investment decisions are made, and that only the most outstanding enterprises end up in an investor’s portfolio. I believe lots of investors would be better off if they adhered to this rule instead of “investing” in every enterprise they come across, justifying this practice by saying “it’s to diversify.”
I have imposed my own limit of how many securities I can purchase in my lifetime: I decided for that number to be 40. At the time of this writing, I have made 6 purchases so far, one that I later had to sell. I have also imposed the additional rule that selling does not mean I regain purchase privileges. My lifetime remaining securities purchases now stands at 34, even though I sold one of my previous holdings.
Thorough analysis cannot be replaced with diversification. I feel that many investors view diversification as their safety net, serving as an excuse for half-hearted analysis simply because they can buy other securities to offset their anticipated mistakes.
What ends up happening is that investors settle for mediocre returns, convincing themselves their lacklustre performance is justified by saying “at least I’m diversified.” This is something many investors forget: overdiversification kills gains. No significant portfolio growth will be achieved if capital is spread too thin.
Instead of viewing diversification as an easy exit, double down on your analysis instead. When purchasing a security or any other investment, I believe in getting it right the first time – being correct right away reduces the need of having to deal with your mistakes later.
Wrapping Up
There is little doubt that diversification is something every investor must account for when creating their portfolios.
I continue to maintain my belief that diversification, though important, is something that should only be done out of necessity. That is, a portfolio that is diversified just enough to ensure uncontrollable risks are kept to a minimum.
When thorough analysis is performed and investment decisions are carefully mulled over, the likelihood of a major risk going undetected decreases, thereby decreasing the need to diversify as well. Diversification should not serve as an excuse to perform half-hearted analysis, believing that any unknowns can simply be diversified away.
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