Sunday, April 22, 2012

Diversification - Part 2 (Guide to Diversification)

Just to recap, these are the 4 major type of risks that we are susceptible to when we are investing:
  1. Systematic Risk
  2. Company/Industry Specific Risk
  3. Human Error
  4. Black Swan
Taking into account these risks, here is my personal guide on how many stocks one should hold:
  1. As many excellent stocks that one can find at a good price
  2. As many stocks as one is able to understand in depth and have the sufficient time to follow
  3. As many stocks as one can have without incurring too much transaction fee in the form of min brokerage fee (not applicable for standard chartered brokerage user) 
  4. As many stocks as you can afford to suffer a total wipe-out in any of the stock.
  5. As little concentration in a similar industry unless you are being kept highly aware of the intimate details of the industry or you are very confident in it.
Rule no 1 is pretty simple as it is one of the best defences against any risks other than human error. An excellent stock is one with an excellent business or one with a very clean balance sheet who can bounce back easily even after what might be a calamity to some. BP is going to survive through the Gulf of Mexico Oil Spill, so has many other companies did in the past – AMEX, GEICO, Adampak, Cerebos. In the case of systematic risk, all one needs to do is to continue to average down without the need to sell them at a discounted price.

Rule no 2 is a guide to the maximum number of stocks that one should have. If you are studying or working, it is pretty unlikely that you can take a portfolio of 10 stocks especially when the reporting season and AGM are here. If you are retiring, it seemed like going for 30 stocks is plausible given that you have all the time in the world and if you are really passionate about it. Going for that many AGMs will also help to enrich your life and prevent degeneration of the brain.

Rule no 3 will apply more for those without as much of a capital at the start. If you are not using Standard 
Chartered brokerage, the brokerage fee is going to eat up a significant amount of your return. Imagine spending $1000 to buy a stock and you will have incurred a total transaction fee of $60 in buying and selling, which will set you back by 6% even before you started out.

Rule no 4 is about the minimum number of stocks that you have. Are you comfortable having a total wipe out of 50%? If not, then you really should not just have 2 stocks in your portfolio. Generally, 4 stocks should be the minimum to prevent a severe hit to one’s portfolio. But then again, rule no 1 will still apply, if you cannot find that many excellent stocks, no point trying to increase your number of stocks. Mediocre business will only bring in mediocre return in the long run.

Rule no 5 is to prevent systematic risk as well as the occurrence of black swan. It is perhaps one of the most tricky as you have to factor in many other factors. Some industries are predominantly less risky than others (VICOM, SPH) where a black swan is really required to destroy them (I have no idea how it can happen; maybe the government decides to revoke their licensesJ). Concentration also has to do with how confident and how well you understand the stocks. That being the case, confidence bias exist and you may still be subjected to human error.

If you are working in the company, it is still wise not to throw all your money into the company though you can have a much higher concentration. The reason is simply because you do not want to get retrenched and suffered capital losses simultaneously should anything happen to the company or industry. Unless you are part of the key management where your job is really to grow the business and enjoy the fruit of your labour.

Generally, the minimum number of stocks that one should hold should be at least 3-4 while the maximum should be really around 30 which will mean you are able to devote 3 days per quarter to each of your companies. The above is my belief on optimum portfolio diversification, please feel free to give any criticism or suggestion.

No comments :

Post a Comment