Diversified Investments: Mediocrity Comes at a Price

by on November 25, 2011

in Public, Value Investing Tips & Articles

Diversified Investments: When More is Less

Asset diversification, as it is practiced today, is a crutch.

From financial advisors, mutual fund industry, media, personal finance bloggers, and every one in between, there is a consensus that diversification is essential for a good portfolio. Nothing can be further than the truth.

If You are Risk Averse, You Should Not be Investing in Stocks – Period

Investing in stocks is the same as investing in businesses on the expectation that the business will create value for the shareholders. Businesses create value by taking risks. This is the whole essence of a market economy – the rewards come in proportion to the amount of risk that is taken. Good businesses take intelligent risks, and those that do not go out of business eventually.

Good businesses also are keenly aware of the market dynamics, adjust their practices accordingly, and take on projects that minimizes overall risk profile of the business at any given time as much as possible. They also pursue new product lines and markets in search for value creation and risk reduction.

Investors in the stock market need to understand that if a business does not take risk to grow shareholder wealth, it is not worth investing in. There is no such thing as steady guaranteed returns with no risk. If that is what you want, you are better off in short term or high quality bonds and money market instruments.

Diversification Does Not Even Address All Risk

Diversification, if done well, reduces the correlation between different assets so the volatility of the overall portfolio is moderated. Which means that if one stock in the portfolio drops significantly, the other non correlated stocks that do not drop as much or increase in value will help the total portfolio avoid the extreme in the decline. Of course, it also works on the flip side – if a stock gains appreciably, the overall portfolio will not gain as much due to other stocks in the portfolio that have not performed as well. Diversification reduces portfolio volatility, so you can sleep better at night.

It does not increase your returns, but it just might decrease it. If you are a believer in diversified investments, and invest in say 100 different stocks, you have probably not done the amount of research and due diligence you should have done before investing in these stocks. It is also not possible for you to effectively monitor each stock in your portfolio. Add in your transaction fees and you have just traded some volatility in return for a portfolio that does not perform as well as it can.

And worse of all, no amount of diversification will save your portfolio from the “market risk”. If the entire economy goes down hill, your portfolio will as well.

Boon for the Mutual Fund Industry

There are some mutual funds that rely on the good old stock picking skills to build a focused portfolio of names that they have a great deal of conviction in. The rest of the industry, and this being the majority, relies on diversification to avoid losing to the index badly. Some years they do better and some years they do worse. On the whole though, there is not much to differentiate one mutual fund from another, except for the fees and expenses.

Most investors fear losing money more than they fear not making money. The concept of diversification speaks to these fears by promising less risk. And of course, mutual funds are great for diversification as they pool money and reduce costs of building a diversified portfolio. Lack of performance is explained away as an overall economic condition that the managers have no control over.

Put it another way, most investors are paying mutual fund managers for the privilege of running a ship that they can’t control.

The situation is similar with financial advisors and the media. No one wants to invest time and research to build a great performing long term portfolio if it means sometimes the portfolio might under perform the market significantly. So every one settles for the mediocre.

Buying Value Reduces Risk And Improves Performance

It is well documented that value investing outperforms growth, and small cap stocks outperform larger company stocks. In fact small cap value stocks deliver better risk adjusted returns than all other asset classes. When you narrow down your investment selection by applying small cap and value filters, the selection is understandably going to be smaller. A 10 – 20 stock portfolio delivers adequate diversification if the stocks are chosen from diverse sectors. This helps moderate the portfolio volatility. Focusing on value and demanding a sufficient margin of safety reduces risk and increases performance over long term.

This also keeps your portfolio manageable so you can properly research and monitor the businesses you own. It does mean more research and analysis to construct a focused portfolio but the rewards of spending some time upfront in due diligence and stock selection can be considerable.

Leave a Comment

Mike Dever November 28, 2011 at 1:16 pm

Diversification is the one true “Free Lunch” in investing. unfortunately, what’s conventionally-preached as diversification really is not. In my book “Jackass Investing: Don’t do it. Profit from it.,” I replace asset classes with “return drivers” and “trading strategies” (as I point out in the book, asset classes are simply long-only trading strategies that do not attempt to disaggregate their many separate return drivers). Once viewed in this fashion it is easy to create a truly diversified portfolio, rather than one constrained by the shackles of asset classes. I’m pleased to provide a complimentary link to one of the book’s chapters here: http://jackassinvesting.com/lookinside/lookinside_chapter_17-77.php

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D'Arcy May 19, 2013 at 5:41 am

What a terrible article.

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Shailesh Kumar May 19, 2013 at 8:50 am

You are free to disagree but it would be nice to know what you are disagreeing with.

From my perspective, I absolutely love people who choose to think with the herd. You are the reason some of us can have outstanding results, so Thank You.

Of course, you may just be disappointed in the grammar or the idiom, in which case my apologies.

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Ian May 20, 2013 at 2:54 am

Very sound and valuable advice! Thanks for your honesty.

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Shailesh Kumar May 20, 2013 at 9:21 am

Thank you Ian! Appreciate you stopping by. Many regards.

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Michael Vasile May 23, 2013 at 1:41 pm

This is ridiculous advice. Diversification reduces volatility while POTENTIALLY reducing returns. You write “It does not increase your returns, but it just might decrease it.” You are completely wrong. For someone who was completely invested in pre-bankrupt banking stocks, diversification would have prevented them from losing all of their money, thereby INCREASING their overall return since it would be more than -100%. It can lower returns, and it can increase returns. Stock investing is as much about minimizing losses as well as maximizing gains.

One should always do due diligence on all stock investments. However, publicly available information is not 100% of the story. There are numerous stocks that have collapsed due to mismanagement, but how about when financial organization stocks tank due to ONE SINGULAR ROGUE TRADER?!?!? Sound familiar. Inside knowledge and opportunities are how big investors make their money, but many of these opportunities are not available to the normal investor.

Your whole argument is based on perfectly picking small numbers of stocks. This isn’t possible. It is a matter of selecting a worthwhile portfolio of value companies and using different sectors, geographic differences, etc. to minimize volatility. With all things being equal, why not invest in high-performing stocks that also help to minimize volatility.

Performing this type of strategy does not equate “to think with the herd”. Look at long-term data analysis, and you can see that diversification provides the best long-term results. Unless you want to suggest that you can predict everything in your crystal ball, this is the best strategy. Your responses to comments sound incredibly arrogant. I am a successful investor — I no longer work because I can effectively live off the returns of my investment. Put your money where your mouth is — anytime you want to have an investment competition, please let me know. Then, from actual performance and empirical evidence, you can learn that diversification is a more successful strategy.

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Shailesh Kumar May 23, 2013 at 1:48 pm

Michael,

Appreciate your point of view. I have done well keeping my portfolio focused on 10-20 uncorrelated stocks and that is enough diversification for me. Anything more is usually an overkill. I would never advise anyone limiting their portfolio to a single sector (like the banking example you gave) and I don’t run my portfolio that way.

You are free to compare your returns to mine. My performance is at the top of this page and I have been putting it up for years. Unfortunately I will have to decline the invitation to compete, but the information is out here and it is regularly updated.

Cheers.
Shailesh

PS. I appreciate contrary points of view and your comment was thoughtful and it clearly explained your position. Where I might have come across as arrogant is my response to one of the earlier comments that merely stated “This is a terrible article”. There was nothing else in that comment to tell me the “why” behind it and these kind of empty comments do not make for a good conversation.

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30 Day Trading May 24, 2013 at 7:06 pm

Diversification definitely does help manage individual asset class risk if allocated across multiple asset classes. However it does have some shortcomings…

1) Diversification does NOT address tail risk (like credit crisis) and the problem of perceived asset class correlation (e.g. bonds up, equity down etc). Traditional advice based on Modern Portfolio Theory (MPT) states that diversification will help because when one asset class goes up, the other goes down – however the major problem with this assumption is that is assumes that the *historical* correlation between certain the asset classes is always going to be same in the future.

As results show from the financial crisis sometimes these correlations breakdown under high stress scenarios – “During times of financial crisis all assets tend to become positively correlated, because they all move (down) together. In other words, MPT breaks down precisely when investors are most in need of protection from risk.” (quoted from criticism of MPT on wikipedia)

2) Over diversification does not necessarily significantly reduce the overall portfolio risk. Research shows that once you get over 10 stock positions in a portfolio the impact of the diversification is significantly diminished.
http://en.wikipedia.org/wiki/Diversification_(finance)#An_empirical_example_relating_diversification_to_risk_reduction

Extreme diversification is a strategy that is used by wealth management divisions to preserve a client’s wealth (typically >$10million) that has already been acquired. It is not necessarily a mechanism to generate returns for people “on the way” to wealth. Additionally it may not be helpful to smaller portfolios. You may also thrash on transaction costs trying to allocate across more stocks and ETFs than is necessary
(especially if you are re-balancing quarterly).

You should probably always have more than 10 individual stock or ETF holdings in a portfolio (preferably spread across different sectors), but no need to over diversify. If you were worried about non-systematic risk (individual stock blowup) maybe Sector ETF’s are a good way to get instant position diversification to reduce that chance that an individual stock underperforms.

For example, Warren Buffet didn’t get rich by over-diversification – he took very large positions in things he believed were undervalued, and waited until the market agreed with him. That is not a diversification strategy. No-one is on the Forbes 100 richest list because they had a steady day job and invested in a wide diversified basket of mutual funds!

3) The other point is that if you are in the market for long enough (long term investor) at some point a tail risk event WILL occur and diversification wouldn’t necessarily save you (e.g. dot COM bust, credit crisis etc).

You should definitely use some diversification but it definitely is not the same as good downside risk management strategy (e.g. we use options, but you could equally use position size loss risk as a % of portfolio (usually only 1% of portfolio risk per position)).
http://www.30daytrading.com/portfolio-principles/

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Shailesh Kumar May 24, 2013 at 7:15 pm

You are making my point better than I did :-)

Thanks for taking the time to read and comment!

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Authentic May 31, 2013 at 4:57 pm

This is not good advice for the average investor. One must diversify to mitigate mistakes. Conditions can and do change for all company’s, sometimes for the better and sometimes for the worse.

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Shailesh Kumar May 31, 2013 at 11:41 pm

Diversify, yes. However after 10-20 stocks, diversification offers diminishing returns.

Average investor is probably better off in a mutual fund if he or she is not able to devote time to properly research stocks for a 10-20 stock portfolio.

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Preston Barr June 5, 2013 at 4:18 pm

A simple cost-benefit analysis of the value created by the marginallaly dimishing risks of diversification would be the best solution for every investor. If 10 researched stocks are sufficient diversification and the costs outweight the benefits on the margin, then do it. There is no singluar way to invest properly. To each his own beautiful.

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Alan June 23, 2013 at 4:02 pm

Nice article. Diversificationas used in this article, of course, assumes diversified within stocks. True diversification looks at the investment vehicles one places their hard earned money on to manage risk while simultaneously increasing return.

I’d diversify within stocks but also use other vehicles such as futures, real estate rentals (not flipping), investing in your career to increase income, taking a second job (e.g. Consulting), writing a book (passive income) or running a business selling real stuff or services. That is true diversification. When the stock market trends downwards, other uncorrelated investments do not necessarily follow suit.

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Shailesh Kumar June 23, 2013 at 4:23 pm

Alan, yes of course! I only address the stock part of an investor’s portfolio, but you are absolutely right.

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Michael M June 23, 2013 at 11:29 pm

After 20 years of study and investing I thoroughly agree with Shailesh’s point of view. If you don’t know or don’t have time you should diversify. Diversification is for the average investor wanting average returns over time. If you want best returns 10-15 well researched stocks at the right time. When the market trends down get out and wait for reentry. If you think it can’t be done. I’m sorry you have not had the good fortune.

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Shailesh Kumar June 23, 2013 at 11:42 pm

Thanks Michael! If average investors knew how much in returns they are giving up over a typical investment horizon of 30 years, by not doing their own research and settling for average returns, I will bet every single one of them would spend few hours a week on their portfolios. The wall street and the investment industry is happy telling every one that the average returns are the way to go and it is all random anyway. Nothing can be further from the truth.

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terry June 27, 2013 at 1:16 pm

Do you have any advice on the best way to find those value stocks or at least where to start looking? What is your opinion on Apple?

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