Wednesday, April 18, 2012

Diversification - Part 1 (Understanding Risk)

Portfolio management is as important as stock selection in investing and determining your return on investment. In this aspect, the extent of diversification has always been debated with some supporting the idea of concentration while some diversifies up to 20-30+ stocks.

Diversification is the act of diversifying where the central idea is the maxim of "Don't put all your eggs in one basket". This is absolutely correct as you will not want to have all your fortunes to be destroyed by a single event. It is also one of the more encouraged methods of reducing investment risk other than hedging in finance. Using Modern Portfolio Theory term, the more independent assets that one has, the lesser the risk will be such that one can drive standard deviation of the portfolio down to nearly zero. The main point that I am trying to drive across is diversification is necessary, though the extent is debatable.

Before I touch on the issue of the number of stocks that we should hold, we need to understand the purpose of diversifying in greater depth. The main purpose of diversification is to reduce potential risks that we are subjected to. Just like in insurance, we are participating in an insurance pool where the risk is being spread over a huge pool of people. As much as we do not want to pay a premium, we can never be assured that misfortune will not strike us. Thus, should the unthinkable occurs, we will still be assured that our family can live on financially sound.

Similarly, we need to UNDERSTAND our needs before we embark on diversifying to avoid paying for redundant policies. Personally, I believe that there are 4 types of risks that we are subjected to:

  1. Systematic Risk
  2. Company/Industry Specific Risk
  3. Human Error
  4. Black Swan
Systematic Risk - those that will affect the entire stock market such that very few stocks can avoid it. These are your wide-reaching recessions like 2008 GFC and 1997 AFC as well as war like in 2003 or even smaller scale crisis like our Euro Debt Crisis today. When they occur, no matter how many stocks you have you will still get hit. With diversification, the chance that you will get a total wipeout is very rare unless you are very unlucky or you are playing with fire (margin). However, a better way of diversifying against such systematic risk is to always buy excellent companies with great business prospect as well as a high quality balance sheet where debt-to-equity ratio is low.

Company/Industry Specific Risk – This is the most diversifiable risk among the 4 simply by reviewing your portfolio and making sure that the correlation among your stocks is not very high. The easiest way is to ensure that your portfolio is not based entirely on the success of one industry or of a single story (for e.g. oil prices). Spamming highly cyclical stocks during a bull market is also not a very good move as these industries are subjected to the same type of cyclical forces. And the key here is not the stock prices but that the profitability of the company will get severely impacted.

Human Error – To err is human, thus we should always take into account that we are being subjected to miscalculation or insufficient understanding. All investors in their lifetime are likely to have made a number of mistakes due to the high emotional and knowledge demand. Even sage like Warren Buffett and Philip Fisher have made numerous flawed investments, why are we to be excluded? Since we are prone to making mistakes, you will not want to pay for the lesson with a big chunk of your wealth.

Black Swan – An event of immense impact whose probability of occurring is nearly zero as nobody will even think of it in the first place. For e.g. Arab Spring, SARS, Black Monday 1987. As there is not a single chance that you will be able to pre-empt it, the key here is still to diversify.

As seen, some of these risks occur simultaneously. For e.g. SARS is a Black Swan, hurts the airline and tourism industry and creates a mild systematic risk. Thus, the idea of running an extremely concentrated portfolio is simply absurd. For Warren Buffett, please take note that he definitely has more stocks and business than anyone else unless you are buying into S&P 500 Index. Should See Candy proves to be poisonous and inedible, Berkshire Hathaway’s profit is not going to take a big hit.

Through understanding the type of risks you are facing, you will be then know how much should you diversify for your portfolio. This will be discussed in part 2.

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