Monday, 20 May 2013

How many baskets?

I'm sure you've all heard that proverb, 'Don't put all your eggs in one basket'. After all, it's taught as the secret to success in business schools and widely preached by financial advisors and commentators. I find this notion paradoxical - diversification is hardly the secret if everyone knows about it, and I don't see droves of investors speeding around in Aston Martins.

Some may disagree with that conventional wisdom. Mark Twain translated it to meaning 'scatter your money and your attention' and instead retorted, 'Put all your eggs in one basket and watch that basket'. Bear in mind that Twain, for all his talents, was not the wisest man in financial affairs, landing in bankruptcy largely due to bad investments.

So here I am to offer my opinion on the merits of a widely diversified investment approach as opposed to a concentrated one. Please note, I'm mainly referring to the field of common stocks, as some strategies such as arbitrage require wide diversification. 

Firstly, let's take a look at the fundamental basis of diversification. The logic goes that if you want to reduce risk, you should buy plenty of stocks (a commonly recommended number is 30) as this reduces the impact on your portfolio of any one stock turning bad. At first glance this seems a very reasonable argument, but this depends on your definition of risk. 

Risk is commonly defined in terms of volatility - either of an individual share price or of the whole portfolio - and in this regard, diversification does help to smooth out volatility and thus reduce overall portfolio risk. But as an investor with a long time horizon, volatility is hardly a risk, rather it presents opportunities to buy stocks when they are cheap. A more rational definition of risk is the chance of a permanent loss of capital over an investor's prospective holding period. If you look at it this way, constructing a huge portfolio of stocks doesn't necessarily reduce risk, diversifying for the sake of it may well increase your probability of permanent capital loss on individual stocks if you don't know what you're doing - Peter Lynch's term 'diworsification' aptly describes this scenario. 

A second justification for wide diversification is that it increases your chances of landing a winning stock. While true, it also increases your chances of picking a dead duck, and in both circumstances, the positive or negative influence on your overall results will be minimal by virtue of the number of stocks you hold. So through wide diversification, one usually edges closer to the average return of the market, which is certainly not a poor return, but there seems a certain irony in going through the effort of picking stocks with the intentional or unintentional goal of attaining average.

I believe buying a low cost index fund is the best approach for people who wish to participate in the historically attractive returns of the share market but don't have the time or ability to research individual stocks. While this kind of extreme diversification may appear to be a lazy attitude, tracking the index over time is better than the professional investment community can hope for - their size, fees and mandates see to that. The huge sway of these institutions explains in part their general advocacy of wide diversification for individual investors. Most of their clients aren't pleased to see huge swings in their account balance from the average return, hence institutions tend to 'hug' the index to avoid volatility and periods of significant underperformance (on the flip side, outperformance too). Although perhaps in an attempt to differentiate themselves, some amusingly have the chutzpah invest in 30 or 40 stocks and then label it a 'concentrated portfolio' or a 'high conviction approach'. 

That brings me to the other end of the spectrum, a highly concentrated portfolio. The principle behind it is simple but very alluring, why put money into your 30th best idea when you have 29 better ones with a higher expected return and lower chance of permanent capital loss? As Warren Buffett explains, 'We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.' And as his pal Charlie Munger puts it, 'To me, it’s obvious that the winner has to bet very selectively. It’s been obvious to me since very early in life. I don’t know why it’s not obvious to very many other people.' He believes that 'The goal of investment is to find situations where it is safe not to diversify'. This is the same logic that one would use in poker. If you want to be any good, you don't bet an equal amount on every hand you get, it's only when you think the probabilities are stacked in your favour do you really raise the stakes. Some in favour of diversification would argue that it is too hard for them to determine which stocks have a higher likelihood of doing well, to which I would counter - then don't play. Again, unless you're confident in your stock picking abilities, you should buy an index fund. 

There are also a couple of sweeteners that come along with a focused approach. By holding a smaller number of stocks, investors reduce their transaction costs from buying and selling, which become quite significant if you're working with small sums of money. Furthermore, one doesn't have to keep track of a vast array of stocks in a concentrated portfolio, this time can be spent keeping a closer eye on existing holdings, searching for new ones, or maybe even not to research stocks. 

From my wording, you can probably tell I've adopted a concentrated style, but this doesn't mean that it is for everyone and that a widely diversified strategy cannot work (although the most successful investors tend to have a concentrated strategy). Take a look at Walter J. Schloss, widely regarded as one of the great investors. He favoured wide diversification, often holding over 100 stocks at a time, enough to start his own stock market index! And yet, his results were significantly above par, producing a 21.3% annualised return from 1956 to 1984, compared to the S&P (including dividends) of 8.4%. I believe the explanation for Schloss' results ultimately lies in his methodology, not the diversification. He strictly adhered to the teachings of Benjamin Graham, who advocated buying a big basket of statistically cheap businesses trading on the stock market. While Schloss' performance could have been improved by focusing on a smaller amount of stocks, each with a higher mathematical expectancy, he didn't like the stress involved in allocating large positions to individual stocks. 

This highlights an important consideration in choosing the appropriate level of diversification. Investing is an inherently psychological game and keeping check of your human instincts is absolutely crucial. You are better off going with a more diversified approach if wild swings in your portfolio value send you into a panic or if a large stock weighting causes you to miss out on a good night's sleep. Many investors adopting a concentrated style need to be wary of becoming emotionally attached to a particular stock they have a lot of money in, subsequently refusing to accept a bad decision. 

Just a couple notes diversification: I hope it is obvious that buying 30 stocks in the same industry is not good diversification as they are all highly correlated. The aim of diversifying is to limit the likelihood of a single bad event destroying your portfolio. I'd argue buying 5-10 stocks in different industries is far more diversified than the above. Also, I don't see much sense in rebalancing portfolios just because certain stocks have risen or fallen in relation to the original purchase price. The primary consideration in buying or selling should be: where is the current value of the business is in relation to what the market values it at? A stock may be justified in rising because the value of the business has increased, and vice versa with a falling stock. But if you rebalance to prevent stocks from reaching an uncomfortably high proportion of your portfolio, for example, because the volatility may make you uneasy, then go right ahead. 

So to sum up: every investor will be comfortable with a different level of diversification, depending on factors such as ability, time, size of portfolio and personal characteristics. However, in general, I believe that if you are serious about investing and know what you're doing, a concentrated approach will produce superior returns to a more diversified one. Mark Twain's guidance is extreme, as relying on one basket is dangerous, but so is stumbling over on too many. I believe in finding a middle ground. 

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