Financial Jungle

This is probably the most abused Warren Buffett quote I’ve read in many financial forums:

Wide diversification is only required when investors do not understand what they are doing.

For one reason or another, investors seem to interpret this as an excuse to concentrate. Let me rephrase the quote a bit.

If you don’t know what you’re doing, you ought to diversify.

Even Buffett, arguably the most astute of all investors, relies on 42 stocks to cut risks. Granted that the high stock count is probably necessary given his enormous wealth. However, if you don’t know what you’re doing, concentrating your stock portfolio will not turn you into an astute investor. Since no investor is omniscient, s/he can cushion any unforeseen blows from company-specific risks, such as strikes and natural disasters, by spreading your eggs to different baskets.

In my own portfolio, I have about 27 core holdings, a number of smaller positions, a couple of ETFs and a handful of mutual funds. Admittedly, the number of holdings seems excessive, but certainly not enough to qualify as diworsification. I don’t have plans to scale down at the present. Being primary a quantative investor, I find the current portfolio quite manageable.

Reduce volatility without sacrificing return
One of my favourite theories is the Modern Portfolio Theory, which goes something like this: when you construct a collection of high-risk, high-reward and uncorrelated stocks, it reduces the volatility of the overall portfolio without sacrificing the expected return. The key is to pick businesses that don’t correlate with each other. That way, individual stocks may oscillate violently around the expected return, but due to the low correlation, the oscillations cancel each other out, and you benefit from a smoother and more consistent return.

Reduce unsystematic risk
Diversification also reduces company-specific risks, also known as unsystematic risks. Examples include strikes at railway companies, broken oil and gas pipelines, and natural destructions by fires and hurricanes. This one goes along the line of not putting all your eggs in one basket. By diversifying, you can improve you odds of hatching most of your eggs.

I’ve been told that investors cannot diversify away from systematic risks, which include inflation, interest rates, recessions and political instability. Even though we can’t eliminate systematic risks, I’m open to the possibility of at least minimizing systematic risks by investing in companies with these characteristics:

• Ability to pass inflationary costs to the customers
• Clean balance sheet to insulate from rising interest rates
• A lineup of consumer stables including essential products and services
• Diversified international revenues

Further readings on diversification:
- Modern Portfolio Theory by Investopia
- Systematic Versus Unsystematic Risks by Investment Review
- How Many Stocks Diversify Unsystematic Risk? by Morningstar