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February 10 2010| Filed Under Auto Insurance, Bonds, Investing Basics, Warren
Buffett
We've all heard the financial experts expound on the benefits of
diversification, and it's not just talk; a personal stock portfolio must be
diversified to some degree. After all, none of us wishes to "put all our eggs
in one basket" and expose ourselves to the inherent risk of holding only one
stock. But can you go too far in spreading your bet? Indeed you can. Here we'll
show you how investors tend to become overdiversified and how you can maintain
an appropriate balance.
What Is Diversification?
When we talk about diversification in a stock portfolio, we're referring to the
attempt by the investor to reduce exposure to risk by investing in various
companies across different sectors, industries or even countries. Most
investment professionals agree that although diversification is no guarantee
against loss, it is a prudent strategy to adopt toward your long-range
financial objectives. There are many studies demonstrating why diversification
works, but to put it simply by spreading your investments across various
sectors or industries with low correlation to each other, you reduce price
volatility. This is because different industries and sectors don't move up and
down at the same time or at the same rate - if you mix things up in your
portfolio, you're less likely to experience major drops, because when some
sectors experience tough times, others may be thriving. This provides for a
more consistent overall portfolio performance. (For background reading, see The
Importance of Diversification.)
That said, it's important to remember that no matter how diversified your
portfolio is, your risk can never be eliminated. You can reduce risk associated
with individual stocks (what academics call unsystematic risk), but there are
inherent market risks (systematic risk) that affect nearly every stock. No
amount of diversification can prevent that.
Can We Diversify Away Unsystematic Risk?
The generally accepted way to measure risk is by looking at volatility levels.
That is, the more sharply a stock or portfolio moves within a period of time,
the riskier that asset is. A statistical concept called standard deviation is
used to measure volatility. So, for the sake of this article you can think of
standard deviation as meaning "risk".
According to the modern portfolio theory, you'd come very close to achieving
optimal diversity after adding about the 20th stock to your portfolio. In Edwin
J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment
Analysis", they conclude that the average standard deviation (risk) of a
portfolio of one stock was 49.2%, while increasing the number of stocks in the
average well-balanced portfolio could reduce the portfolio's standard deviation
to a maximum of 19.2% (this number represents market risk). However, they also
found that with a portfolio of 20 stocks the risk was reduced to about 20%.
Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio's
risk by about 0.8%, while the first 20 stocks reduced the portfolio's risk by
29.2% (49.2%-20%).
Many investors have the misguided view that risk is proportionately reduced
with each additional stock in a portfolio, when in fact this couldn't be
farther from the truth. There is strong evidence that you can only reduce your
risk to a certain point at which there is no further benefit from
diversification.
True Diversification
The study mentioned above isn't suggesting that buying any 20 stocks equates
with optimum diversification. Note from our original explanation of
diversification that you need to buy stocks that are different from each other
whether by company size, industry, sector, country, etc. Put in financial
parlance, this means you are buying stocks that are uncorrelated stocks that
move in different directions during different times.
As well, note that this article is only talking about diversification within
your stock portfolio. A person's overall portfolio should also diversify among
different asset classes, meaning allocating a certain percentage to bonds,
commodities, real estate, alternative assets and so on.
Mutual Funds
Owning a mutual fund that invests in 100 companies doesn't necessarily mean
that you are at optimum diversification either. Many mutual funds are sector
specific, so owning a telecom or healthcare mutual fund means you are
diversified within that industry, but because of the high correlation between
movements in stocks prices within an industry, you are not diversified to the
extent you could be by investing across various industries and sectors.
Balanced funds offer better risk protection than a sector-specific mutual fund
because they own 100 or more stocks across the entire market.
Many mutual fund holders also suffer from being over-diversified. Some funds,
especially the larger ones, have so many assets (i.e. cash to invest) that they
have to hold literally hundreds of stocks and consequently, so are you. In some
cases this makes it nearly impossible for the fund to outperform indexes - the
whole reason you invested in the fund and are paying the fund manager a
management fee.
Conclusion
Diversification is like ice cream: it's good, but only in reasonable
quantities.
The common consensus is that a well-balanced portfolio with approximately 20
stocks diversifies away the maximum amount of market risk. Owning additional
stocks takes away the potential of big gainers significantly impacting your
bottom line, as is the case with large mutual funds investing in hundreds of
stocks. According to Warren Buffett: "wide diversification is only required
when investors do not understand what they are doing". In other words, if you
diversify too much, you might not lose much, but you won't gain much either.