How Much to Diversify Your Portfolio?
How Much to Diversify Your Portfolio?
“Always keep your portfolio and your risk at your own individual comfortable sleeping point.”
-Mario Gabelli
When you carry only one stock in your portfolio, you’ve put all your eggs in one basket. Any fall in the price of the scrip will hit you. If your software export company is quoted at ₹100 and the auditor of the company qualifies the financial statements, as a knee-jerk reaction, your scrip falls to ₹80. One remark has wiped off 20% of your capital. The solution is to diversify. However, not all risks can be mitigated by diversification.
While diversification may help you mitigate the specific risk, it does not mitigate the market risk. The specific risk is peculiar to a company or a small group of companies. Workers’ unrest leading to the closure of the Tuticorin plant of Sterlite Industries is an example of a specific risk. The good news is that the specific risk is diversifiable. Statistics say just by owning 2 stocks, you have eliminated the specific risk of owning 1 stock by 46%; 4 stocks will reduce your risk by 72%; 16 stocks by 93%; and 500 stocks by 99%.
It does not matter if the above statistics are accurate or not; however, they bring out an important principle. As you move from 1 stock to 2, you reduce the risk. Moving up with every stock added to your portfolio, the specific risk reduces, but beyond a number, around 20 stocks, the gain is not substantial. Thus, while owning 500 stocks will nearly eliminate your specific risk, it will not be a prudent thing to do. Let us see why.
While buying 2 stocks instead of 1 has reduced your risk by 46%, it has also reduced the reward ratio to that extent. Taking the example further, if a sudden improvement in the results of your stock causes the price to rise by ₹20, your gains on a ₹100 stock will be 20%. However, if you have diversified into another company and are now holding 1 share of the other company that’s, let us say, priced again at ₹100, a rise of ₹20 in the price of your first stock will now translate into a 10% gain in your portfolio instead of 20%.
Diversification is desirable as long as the mitigation of risk arising out of diversification outweighs the dilution in appreciation that may happen because of diversification. A number between 10 and 20, depending upon your risk appetite and the sectors and the company you invest in, should be an optimum diversification. The tendency of most investors is to diversify so much that their portfolio looks like a miniature model of the whole market, a poor strategy. Worse, when diversification is in inferior-quality stocks, the basket only has rotten apples and will under-perform even the indices and may be called ‘diworsification’.
Diversification does not mitigate market risk. Market risk is the possibility of a loss occurring to an investor which is caused by the performance of the overall market. Market risk is the systematic risk in the sense that it affects the entire system. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. This risk cannot be eliminated though it can be hedged against.
Templeton versus Buffett
The successful investor Sir John Templeton says, ‘Diversify. In stocks and bonds, as in much else, there is safety in numbers.’ Equally successful investor Warren Buffett takes the opposite view and says, ‘Wide diversification is only required when investors do not understand what they are doing.’
Buffett quoted Mark Twain: ‘Behold, the fool saith, “Put not all thine eggs in the one basket”—which is but a matter of saying, “Scatter your money and your attention”; but the wise man saith, “Put all your eggs in the one basket and—WATCH THAT BASKET.”’
Other successful investors like George Soros, William J. O’Neil, and Bernard Baruch are also known to recommend a concentrated position.
Charlie Munger says, ‘This worshipping at the altar of diversification, I think that is really crazy.’ Munger discovered that if we can find companies with great economics that continue to grow year on year, creating an additional margin of safety on the go, we must concentrate on them. That way, we may reduce the number of companies to ten. ‘You should remember that good ideas are rare,’ he would say. ‘When the odds are greatly in your favour, bet heavily.’
So what’s the right approach? Buffett himself recommends that passive investors who do not have the time or inclination to research the stocks will be better off by investing in indices. An index is nothing but a bundle of shares, so investing in indices means a broad diversification. This may look like a contradiction, but it is not. If you can understand the business so well, you can trust all your eggs in that basket. You may do that, but if you do not, spread them in different baskets. Investors like Warren Buffett have the acumen and resources to know a business inside out and can afford less diversification, but for retail investors, what we discussed earlier sounds logical, diversifying in about 20 stocks.
Diversify less, and you must have the acumen to watch that basket carefully. One rotten egg and the valuation is severely impaired. A one-star performer may bring about fantastic returns on your investment. This approach is more suitable to larger investors, who have resources to attend to each of the conference calls of companies they own and can keep track of every single piece of information concerning those companies.
If you diversify too broadly, as explained above, you are becoming something similar to the index, and your chance of beating the index is bleak. If you diversify too much, it becomes impossible to keep track of the updates pertaining to each of the stocks you own, and you end up becoming a passive investor, a mirror of the index fund. Diversification to the extent of around 20 companies is ideal. You may track each company. Reading 20 financial statements every year and as many results, every quarter is no big deal and is easily doable.
My strategy is to buy about 20 stocks in unrelated sectors. When one sector (let us say technology) is on the rise, the speculators would often square up their holdings in another sector which seems slow (let us call it FMCG) and pour it over the momentum. This fuels a further rise in the technology sector, causing a fall in FMCG. When the reversal of trend happens, the money will flow out of technology and get into some another sector that is rising. Diversification across sectors provides a balance against this sectoral bias. Since we invest in a few securities, the number of companies we invest in must be evenly distributed across sectors, though sometimes we may find two or three companies in a particular sector which are attractive investments.
To sum up the discussion, diversification is a matter of individual choice. More knowledgeable investors may diversify less. An average investor should diversify sufficiently, say 20 stocks, to mitigate the effect of a couple of bad investments.
(Dr. Tejinder Singh Rawal is the author of the best-selling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
“Always keep your portfolio and your risk at your own individual comfortable sleeping point.”
-Mario Gabelli
When you carry only one stock in your portfolio, you’ve put all your eggs in one basket. Any fall in the price of the scrip will hit you. If your software export company is quoted at ₹100 and the auditor of the company qualifies the financial statements, as a knee-jerk reaction, your scrip falls to ₹80. One remark has wiped off 20% of your capital. The solution is to diversify. However, not all risks can be mitigated by diversification.
While diversification may help you mitigate the specific risk, it does not mitigate the market risk. The specific risk is peculiar to a company or a small group of companies. Workers’ unrest leading to the closure of the Tuticorin plant of Sterlite Industries is an example of a specific risk. The good news is that the specific risk is diversifiable. Statistics say just by owning 2 stocks, you have eliminated the specific risk of owning 1 stock by 46%; 4 stocks will reduce your risk by 72%; 16 stocks by 93%; and 500 stocks by 99%.
It does not matter if the above statistics are accurate or not; however, they bring out an important principle. As you move from 1 stock to 2, you reduce the risk. Moving up with every stock added to your portfolio, the specific risk reduces, but beyond a number, around 20 stocks, the gain is not substantial. Thus, while owning 500 stocks will nearly eliminate your specific risk, it will not be a prudent thing to do. Let us see why.
While buying 2 stocks instead of 1 has reduced your risk by 46%, it has also reduced the reward ratio to that extent. Taking the example further, if a sudden improvement in the results of your stock causes the price to rise by ₹20, your gains on a ₹100 stock will be 20%. However, if you have diversified into another company and are now holding 1 share of the other company that’s, let us say, priced again at ₹100, a rise of ₹20 in the price of your first stock will now translate into a 10% gain in your portfolio instead of 20%.
Diversification is desirable as long as the mitigation of risk arising out of diversification outweighs the dilution in appreciation that may happen because of diversification. A number between 10 and 20, depending upon your risk appetite and the sectors and the company you invest in, should be an optimum diversification. The tendency of most investors is to diversify so much that their portfolio looks like a miniature model of the whole market, a poor strategy. Worse, when diversification is in inferior-quality stocks, the basket only has rotten apples and will under-perform even the indices and may be called ‘diworsification’.
Diversification does not mitigate market risk. Market risk is the possibility of a loss occurring to an investor which is caused by the performance of the overall market. Market risk is the systematic risk in the sense that it affects the entire system. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. This risk cannot be eliminated though it can be hedged against.
Templeton versus Buffett
The successful investor Sir John Templeton says, ‘Diversify. In stocks and bonds, as in much else, there is safety in numbers.’ Equally successful investor Warren Buffett takes the opposite view and says, ‘Wide diversification is only required when investors do not understand what they are doing.’
Buffett quoted Mark Twain: ‘Behold, the fool saith, “Put not all thine eggs in the one basket”—which is but a matter of saying, “Scatter your money and your attention”; but the wise man saith, “Put all your eggs in the one basket and—WATCH THAT BASKET.”’
Other successful investors like George Soros, William J. O’Neil, and Bernard Baruch are also known to recommend a concentrated position.
Charlie Munger says, ‘This worshipping at the altar of diversification, I think that is really crazy.’ Munger discovered that if we can find companies with great economics that continue to grow year on year, creating an additional margin of safety on the go, we must concentrate on them. That way, we may reduce the number of companies to ten. ‘You should remember that good ideas are rare,’ he would say. ‘When the odds are greatly in your favour, bet heavily.’
So what’s the right approach? Buffett himself recommends that passive investors who do not have the time or inclination to research the stocks will be better off by investing in indices. An index is nothing but a bundle of shares, so investing in indices means a broad diversification. This may look like a contradiction, but it is not. If you can understand the business so well, you can trust all your eggs in that basket. You may do that, but if you do not, spread them in different baskets. Investors like Warren Buffett have the acumen and resources to know a business inside out and can afford less diversification, but for retail investors, what we discussed earlier sounds logical, diversifying in about 20 stocks.
Diversify less, and you must have the acumen to watch that basket carefully. One rotten egg and the valuation is severely impaired. A one-star performer may bring about fantastic returns on your investment. This approach is more suitable to larger investors, who have resources to attend to each of the conference calls of companies they own and can keep track of every single piece of information concerning those companies.
If you diversify too broadly, as explained above, you are becoming something similar to the index, and your chance of beating the index is bleak. If you diversify too much, it becomes impossible to keep track of the updates pertaining to each of the stocks you own, and you end up becoming a passive investor, a mirror of the index fund. Diversification to the extent of around 20 companies is ideal. You may track each company. Reading 20 financial statements every year and as many results, every quarter is no big deal and is easily doable.
My strategy is to buy about 20 stocks in unrelated sectors. When one sector (let us say technology) is on the rise, the speculators would often square up their holdings in another sector which seems slow (let us call it FMCG) and pour it over the momentum. This fuels a further rise in the technology sector, causing a fall in FMCG. When the reversal of trend happens, the money will flow out of technology and get into some another sector that is rising. Diversification across sectors provides a balance against this sectoral bias. Since we invest in a few securities, the number of companies we invest in must be evenly distributed across sectors, though sometimes we may find two or three companies in a particular sector which are attractive investments.
To sum up the discussion, diversification is a matter of individual choice. More knowledgeable investors may diversify less. An average investor should diversify sufficiently, say 20 stocks, to mitigate the effect of a couple of bad investments.
(Dr. Tejinder Singh Rawal is the author of the best-selling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
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