To Diversify Or Not To Diversify?
Summary Investment risk – or probability of losing money – can’t be measured precisely (outside of casinos and some other narrowly defined domains). It’s impossible to predict how a stock will perform in the future; sometimes the safest-looking stocks turn out to be the riskiest. Which is why it’s never wise to put all of your eggs in one basket… if the basket is dropped, all is lost. Diversification is a more robust approach, because it allows you to make (small) mistakes without destroying your portfolio. When one asks me how I can best describe my experiences of nearly forty years at sea, I merely say, uneventful. I have never been in any accident of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked, nor was I ever in any predicament that threatened to end in disaster of any sort. The above quote comes from a 1907 interview with Captain E. J. Smith. Five years later, he was captain of the Titanic when it hit an iceberg and sank. More than 1,500 people, including him, went down with the ship. The Titanic disaster illustrates perfectly the dangers of inferring the future from the past. Just because something hasn’t happened before doesn’t mean it’s impossible. It sounds almost too obvious, but it’s a common mistake made in the world of finance. Consider the story of the infamous hedge fund Long-Term Capital Management (LTCM). Like the Titanic, LTCM was supposed to be “unsinkable.” It was run by a so-called “dream team” of Wall Street professionals, academics, and two Nobel Prize winners, all of whom – like Captain Smith – had impeccable track records. But then in 1998, after only four years in operation, the excessively leveraged LTCM collapsed like a house of cards. This time, the iceberg was Russia defaulting on its debt – something LTCM’s risk models, which relied on limited historical data and phony bell curve-style statistics, never saw coming. Unfortunately, LTCM wouldn’t be the last to make this mistake. This same over-reliance on flawed risk models later led to the 2008 financial crisis, resulting in the demise of many major financial institutions, most notably Lehman Brothers. These disasters have taught us that financial markets aren’t a casino with simple bets; real-world risks are more complex and can’t be measured precisely. Historical data never fully reflects all of the possible events that could take place (recall Captain Smith who “never sunk before”). Moreover, statistical risk-measuring tools are largely useless, particularly when dealing with rare events (i.e., black swans). The best way around this risk measurement problem is to simply ignore it, and focus on the consequences instead. For example, I don’t know the odds of an earthquake in Tokyo, but I can easily imagine how a heavily populated city like that might be affected by one. Similarly, it’s easy to tell that a highly leveraged bank is doomed should a crisis occur, but predicting when and how severe that crisis will be is a fool’s game. In short, it’s much easier to understand if something is harmed by shocks – hence fragile – than try to forecast harmful events. This whole notion of fragility has important implications in portfolio management, particularly when it comes to deciding how many stocks to hold. There are two schools of thought on this. One suggests that we should spread our eggs across many baskets. The other says that it’s better to put all your eggs in just one basket and then watch it carefully. So, who’s right? The school advocating broad diversification is, because it makes your portfolio less fragile to bad bets. The critics, however, claim that diversification is a recipe for mediocre returns. You don’t get on the Forbes Richest List by diversifying, they argue, but by concentrating your bets on few stocks. It’s true. You probably won’t become a billionaire by holding a well-diversified portfolio. But the reverse is also true – those on the “Fools Gone Broke List” also concentrated their bets, and paid a big price for it. Ignoring these losers is financial suicide. The point is, concentrated investing is like playing the lottery – you could get lucky and win big, but it’s far more likely that you’ll lose. Diversification, on the other hand, is insurance against the extreme unpredictability of any one stock. It makes your overall portfolio more robust, preventing one or two losers from ravaging your wealth. So, how many stocks do you need to be sufficiently diversified? A simple way to approach this question is to ask yourself: What’s the most I can afford to lose if one of my stocks goes bankrupt? For the typical investor, it’s about 5% – the equivalent of owning 20 stocks in equal proportions. Now, let’s view this from another angle. Owning just 10 stocks eliminates 51% of portfolio volatility (i.e., diversifiable risk). Adding 10 more stocks eliminates an additional 5% of the volatility. Increasing the number of stocks to 30 eliminates only an additional 2% of the volatility. And that’s where the good news stops, as further increases in the number of holdings don’t produce much additional volatility reduction. In short, it’s possible to derive most of the benefits of diversification with a portfolio consisting of 20 to 30 stocks (assuming they’re diversified across industries, geographies, and market capitalizations). Contrary to what the critics often claim, adequate diversification doesn’t require 100-plus stocks in a portfolio. The Benefits of Diversification Note: Portfolios are equally weighted. Volatility is calculated as the annualized standard deviation of historical stock price returns. Source: A North Investments, Elton and Gruber Study The central idea of this article is that investment risk (or the probability of losing money) can’t be measured precisely. It’s impossible to predict how a stock will perform in the future. Even the safest-looking stocks can surprise you. Remember Enron? Before it became a symbol of corporate fraud and corruption, Enron was widely regarded as one of the most innovative, fastest-growing, and best managed companies in the world. It was the “darling of Wall Street,” a stock you could “buy and hold for a lifetime.” It was rated a “buy” or “strong buy” by most analysts. Thousands of investors put their life savings into the stock, thinking it was a “sure thing.” Most would never see their money again. Enron is the perfect example of why you should never put all of your eggs in one basket. If the basket is dropped, all is lost. Diversification, on the other hand, allows you to make (small) mistakes without destroying your portfolio. It’s a more robust investment approach. Some call it “protection against ignorance,” and they’re absolutely right. We’re all ignorant; some of us just don’t realize it yet.