Diversification, as defined by the experts, is a risk management process of allocating capital in a way to reduce overall risk by investing in a variety of assets.
Before asking what financial risk truly means to you but let us first introduce what majority of the finance industry believes risk to be.
Here is a short excerpt adapted from Investopedia:
“Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns…”
CAPM is frequently used in pricing models which supposed to show a linear relationship between risk, defined as beta, and returns. They believe that with the greater risk taken, there should be greater returns. A portfolio manager should then be expected to strive for the highest return/risk ratio possible, under any restrictions.
Take for example, a typical risk-averse investor would not be expected to invest most of the capital in a single industry. If Goldman Sachs and JP Morgan aren’t performing, it would likely mean that HSBC, Morgan Stanley and other major international banks aren’t doing that great either. Hence, to prevent suffering during downtimes, investors are advised to diversify from purely investing in one sector and perhaps invest in a few others such as healthcare, which is known to be counter-cyclical.
However, does this diversification approach align with our value investing philosophy of reducing risk?
What does risk mean to a value investor?
Firstly, there is a wide consensus amongst value investors that risk should not be viewed as beta, volatility of stock price. As our time horizon is typically more than 1-2 years, any volatility of stock prices in the short term will not pose any permanent risk to our investments.
The true risk that value investors should be concerned about is the risk of a permanent loss of capital. In other words, how likely is it for the company to go bankrupt?
If you approach risk from this angle, you will not only seek to reduce the loss of capital, but also maximize your returns. As value investors, we are interested in returns on capital and returns of capital
In other words, if you take care of your downside, the upside will take care of itself.
Who says risk and reward are necessary trade-offs?
Diversification or not?
Now that we have debunked the conventional misconception of portfolio risk, our objective shouldn’t be to reduce the volatility of our portfolio but to avoid any permanent loss of capital.
So here is what the father of value investing, Benjamin Graham, has to say about diversification.
Investing, to value investors, is a probability game. Successful value investors tilt the odds of winning heavily in their favor so that they will generate above-average profits in the long run.
No doubt there must be sufficient margin of safety that must be accounted for in individual stocks but to be even more conservative, diversification will increase the overall success rate of making more correct bets. The larger your portfolio, the closer your results will be to the expected returns.
One more thing to note, diversification in this case is no longer to reduce the fluctuation of stock prices, but to provide sufficient buffer in the event that you made the wrong judgement or certain unfortunate events would to happen to the company.
Caveats on diversification
Before you begin to flood your portfolio with a ton of stocks, you must be aware of the side-effects of diversification.
Firstly, while in theory diversification makes a lot of sense, we are all limited by our ability to pick multiple good investments. After all, how could our 100th idea be as good as our 5th idea. By over diversifying, it would simply lead to diminishing margin of returns.
Secondly, diversification is after all, at high levels, a fool-proof mechanism to prevent investors from suffering too much of a loss. Warren Buffett has repeatedly voiced his concerns about diversification where those who aren’t suited to pick winners should instead invest in a low-cost index instead.
“The goal of a nonprofessional should not be to pick winners – neither he nor his helpers can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” Warren Buffett
This only comes to show that value investing is a truly arduous task that not all are cut out for it. If you aren’t willing to put in so much effort, Warren believes that you are better off investing your capital into a low-cost portfolio instead of attempting to pick stocks without the necessary knowledge.
With great returns comes great effort and discipline.
Lastly, the need for diversification is dependent on the accuracy of your judgement. If you have done extensive homework and made a good judgement about your investments, it is not necessary to diversify your holdings across different sectors and industries.
Warren believes that the more certain you are about your judgement, the greater the proportion of capital should be invested accordingly. There is a lesser need for diversification as you make a better judgement.
Through this article, we hope that you have gained a better idea of risk and its relationship to diversification its role in your portfolio. The finance industry very often has a different set of definition of risk and diversification from value investors. You should exercise careful judgement and consider whether these terms fit your philosophy before taking them in.