Aaah, yes.  This is the page for us to share our thoughts and ideas with you, whether you like it or not!  We want to make everyone, including your editor, think intelligently.  Not surprisingly, the topics will be mostly investment focused but don't be surprised if from time to time, we stray a little from that subject.  You can expect some bold and passionate statements with a dash of controversy and perhaps some humour sprinkled in too.   Oh and probably some sarcasm, I like sarcasm.

We want to hear back from you with intelligent input, rebuttals and other positive contributions, to keep us all thinking at an intelligent level.  Through this process, we can all learn things of value.

 

 
I thought so


December 28, 2011
Diversification

 

Diversification – Definition 

1.     To give variety to; vary: diversify a menu.

2.     To extend (business activities) into disparate fields.

3.     To distribute (investments) among different companies or securities in order to limit losses in the event of a fall in a particular market or industry.  (http://dictionary.reference.com/)

A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes, industries, or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.  (http://www.investorwords.com/)
 
Diversification.  We all know what it is and the fact that we need it but many of us are uncertain when we need to decide how much we need for our portfolios.  If your subscription to BOTD is your sole source of investment advice and you follow the guidance provided, will you have a prudent amount of diversification?  After all, we are only selecting form a list of 30 companies.  Fair question.  The answer is a resounding, yes!  I can say that with complete confidence because, what you must realize, is that the list of thirty companies we are choosing from has already been analyzed and met investment quality and diversification requirements.  The complete list is a proxy for the US market, at least for the large capitalized companies.  From that list of investment quality companies, we are recommending the top companies for you to invest in based on their intrinsic value relative to their quoted price.
 
Many investment professionals will have different answers regarding the required level of portfolio diversification.  You must keep in mind why you are diversifying.  For that answer, go back and read definition 3.  As with many things, the devil is in the details.  You are diversifying to reduce risk.  BUT what type of risk?  Keep in mind that no matter what you do, you cannot diversify away all risk.  Simply put, business and investing, like life, is full of risks and all different kinds.  There are absolutely no guarantees anywhere, regardless of what the ads say.  What you need to focus your energies on is increasing your chances of success by investing in companies that  are simple to understand, have a good operating history and favorable prospects with good management and can be purchased at a significant discount to their intrinsic value.   If this is done successfully then you will have reduced the risk of investing in a business failure. Other risks will still likely be very real.  Decide what risks you are prepared to accept and avoid the ones you are not.  Sorry if that seems blunt but there is no magic answer.

When you are deciding how much to diversify, we would suggest some basic questions for you to answer:

How many different investments can I competently follow?

    • Do I understand what I invested in?
    • How much overlap is there in my investment positions?
    • Do I have enough diversification to spread out risk?
    • Do I have too much diversification to realize favourable results?

This is not a definitive list but simply some key points for your consideration.

If you listen to or read the money managers in the various general media outlets and try to follow their advice then you will find yourself investing in everything!  Do you think that is necessary?  I sure don’t.  It’s not practical either. 

Your initial ideas of investing likely included investing mutual funds, stocks, bonds and real estate.  As your research expanded, you probably learned about commodities like gold and silver.  That realization expanded your knowledge to include other precious metals, rare earth metals, pork bellies, orange juice, coffee, wheat, etc..  Whoa! That may have seemed a bit to exotic and overwhelming for you, so you went back to deciding about bonds. 

That’s simple, right?  There are T-Bills, commercial paper, government and corporate bonds.  Seems simple.  Did you include the high yield category and having to decide what duration of bonds you need?  And of course there are still convertibles to consider.

So now you’re thinking you’ll stick to just stocks and mutual funds.  Ok, but of course your research will guide you to include large, mid and small caps.  Then you’ll need to make sure you cover of the various sectors; consumer discretionary, consumer staples, energy, financials, health care etc.. 

And last but not least, you’ll be told to diversify away currency risk.

In case your thinking it’s all to confusing and you’ll do nothing and be safe, think again.  There is always inflation risk.  Ignoring inflation will make certain that you will have less later than what you have now.

While I have just provided you with a broad list of choices and corresponding risks, it is by no means all-inclusive.  It does illustrate that you need to make some decisions.  Since you can’t cover all the choices I suggest that you construct a simple portfolio that you can understand, have the time to monitor and lets you sleep comfortably.

It’s right to diversify your investments, because if you only hold one investment and it turns out poorly then you are in big trouble.  If that poor investment is only one of several then it becomes less troublesome and less of a serious concern to your total portfolio performance.  No matter how much research and analysis is done, you can’t be completely certain of any one single investment turning out favorably and statistics show that everyone is bound to end up with the occasional underperformer in their portfolio.  If Warren Buffet and Charlie Munger have bought some stinkers then the rest of us are likely to buy some not so great investments as well.

So how much diversification is the right amount?  That depends. A terribly safe answer, isn’t it?  In my humble opinion, the amount only depends on your level of comfort and confidence in your investments. 

It is a fact that the lower the number of investments you have in your portfolio the more volatile it is likely to be.  However, volatility is not necessarily a bad thing.  Warren Buffet, in many of his letters to shareholders has frequently stated “I would much rather earn a lumpy 15% over time than a smooth 12%”.  If you are confident in your purchases then the dips present a nice buying opportunity.  Besides, volatility is only the measure of the movement of a security’s quoted price, not its actual value.  And if you are holding a stock for the income that it generates for you then the price movement of that stock should concern you even less. 

Benjamin Graham said that you should have a minimum of ten and a maximum of perhaps thirty common stocks in your portfolio.  Consensus amongst modern finance authors and instructors is that the majority of market risk is diversified at a level of approximately twenty holdings and that anything over forty holdings provides no measurable benefit regarding diversification.  There is much written on this subject but despite the all efforts there is no definitive answer. 

I would suggest to you that the answer depends on several factors including; the size of your portfolio, your comfort level concerning volatility, the amount of time and ability you have for research and monitoring of investments as well as the level of confidence you have in your investments.

But does that mean that any more is counterproductive?  Does that mean that less is irresponsible? 

There are valid points in the debate over diversification.  There are some, like Philip A. Fisher, another extremely successful and highly regarded investor, that believe that you should not have more than about 10 investments in your portfolio for some very sound reasons.  One main argument is that Mr. Fisher believes investors use diversification as an attempt to cover up their level of guesswork in constructing their portfolios.  The argument is that an investor should be more thorough and rational in his/her decision and only invest when they are completely confident in the quality of the investment.  Once the investor is confident in the prospects of the investment, he/she should invest heavily in the few investments that they are so confident about rather than sprinkle their funds over a larger number of investments that they are guessing about.  Mr. Fisher strongly believes that large diversification is a sign of incompetence.  Warren Buffet’s long time partner Charlie Munger, concurs by investing in a concentration of well-chosen holdings that he knows very well.  Charlie has on occasion stated that the quantity of an investor’s holdings rises in proportion with his/her level of uncertainty and incompetence.

The time argument is one of a fairly practical nature; it is increasingly more difficult and time consuming to properly learn about the business of each company, monitor their operations and evaluate their performance and valuation as you include more and more companies in your portfolio.

As a polar opposite example, Peter Lynch, a famous and successful mutual fund manager at Fidelity Investments, managed his fund to an average annual return of 29.2% from 1977 to 1990.  When he resigned, his fund had over 1000 individual positions.

Please remember that you can’t diversify all risk and nor do you want to.  The risk you should take on is that of any other business owner, since your investment has now made you a part owner of that business.

One other seemingly obvious point about diversification must be mentioned.  Simply having a large number of investments does not provide you with adequate diversification.  If an investor has holdings in thirty-two clothing store chains then, despite the number of holdings, they are not adequately diversified.  Diversification means not only holding investments in a broad number of investments but also that those investments are from a broad range of different industries.  Most investors are aware of the fact that different industries perform better at different times and so it would benefit you to hold a range of investments across a number of industries at any given time.  This will allow you to benefit from these favorable conditions when they arise.  So if you know someone who has six mutual funds and they are all invested in USA Blue Chip equities then you can confidently explain to then that they are not properly diversified and wisely recommend they should have a look at one of Helden Wealth’s services at www.heldenwealth.com to address the problem and save money too.  What a brilliant and shameless plug!

So what should an intelligent investor do?  Do what you’re comfortable with.  The central point is that you don’t need to (and you physically can’t) invest in everything.  When you read the attached copy of “The Superinvestors of Graham and Doddsville”, you will have excellent guidance to your answer. 

 

And from the best...

Theory of Diversification 

                ' There is a close logical connection between the concept of a safety margin and the principle of diversification.  One is correlative with the other.  Even with a margin in the investor’s favor, an individual security may work out badly.  For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible.  But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.  That is the simple basis of the insurance underwriting business. 

                Diversification is an established tenet of conservative investment.  By accepting it so universally, investors are really demonstrating their acceptance of the margin of safety principle, to which diversification is the companion.  This point may be made more colorful by a reference to the arithmetic of roulette.  If a man bets $1 on a single number, he is paid $35 profit when he wins – but the chances are 37 to 1 that he will lose.  He has a “negative margin of safety”.  In his case, diversification is foolish.  The more numbers he bets on, the smaller his chances of ending with a profit.  If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.  But suppose the winner received $39 profit instead of $31.  Then he would have a small but important margin of safety.  Therefore, the more numbers he wagers on, the better his chances of gain.  And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. '

The Intelligent Investor, Benjamin Graham

Page 282-283

 

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