Diversification of Equities

The art of diversification is to hold enough different investments to reduce volatility and the risk of loss to acceptable levels, but not to hold so many as to reduce returns too much either, nor to dilute your conviction on a particular stock(s).

If you have done due diligence on a stock and have a strong view it is in value, then you should back your view with a meaningful weighting in your portfolio. We view optimal diversification for the serious personal investor as 12 – 20 securities because returns on portfolios with more than this many stocks start to approximate market returns – defeating the purpose of a concentrated portfolio.

It is difficult for many personal investors to find the time to cover more than 20 companies in sufficient detail to avoid surprise losses from earnings downgrades, though people who do have the time could consider a professional-size portfolio of 15 – 30 securities.

Prudent value investors consider the individual risks in each security when diversifying their investment funds. For example, a high risk stock requires a more conservative position: a smaller or even nil weighting in the portfolio. To help assess a stock’s risks we need to consider a company’s required return and their CQR (financial health), two measures developed by Clime to:

  1. reassess your current holdings; and
  2. evaluate future holdings before purchase.

When the required return is low and the quality rating is high you are likely to have found an investment-grade company.

Regardless of a stock’s risk profile, be cautious about investing more than 10% in any one security. This helps protect the portfolio’s overall performance against any unforeseeable events. Your maximum weightings are of course up to you; we recommend 10% as our general guide.

But it is still riskier to hold a large number of stocks one does not understand than a smaller number understood well. Over time you will always make more money investing in businesses you understand than buying stocks on whims or tips, or because they are prominent names or widely owned.

To quote Warren Buffett, “Never invest in a business you cannot understand. If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”

Ultimately the purpose of diversification is to manage the risks of not knowing what you are doing. Plenty of fortunes have been made by owning concentrated portfolios. You need to be able to look at yourself in the mirror and be honest you know enough about a business to be a part-owner. Remember we treat shares not as trading chips in a casino but as units of ownership in companies. Value investors think and act like owners of a business.

Our number one point about diversification is not to invest a large proportion of your portfolio in a stock only because it screens as deeply undervalued. A stock may well be in value on our assumptions but you must not buy it unless the risks of owning that business are within your risk tolerance.

Do you really want to put 20% of your portfolio into a stock with a 16%+ required return and a low quality rating, even if it is in value? We would advise conservative investors, who are the bulk of self-directed personal investors in Australia, to limit exposure to such stocks to less than 5% of their portfolios, if that, even if they seem deeply undervalued. Except in toppy bull markets it is unlikely there will not also be higher-quality stocks you could buy cheaply.

Diversification by sector and market capitalisation are also important because sectors and stocks of particular market caps can be correlated. Correlation measures how closely the prices of investments move together. When making an investment decision, one should consider the historical correlation of the individual investments. The correlation of individual stocks within a sector is historically higher than individual stocks in different sectors, and some sectors are correlated with each other.

Similarly individual stocks of similar market capitalisation are broadly correlated. When investing in a diversified portfolio investors with only a moderate tolerance for portfolio volatility should choose stocks with uncorrelated returns. This protects against poor market performance in individual sectors of your portfolio. For example, a portfolio of 15 – 30 small-cap mining services stocks would not be appropriately diversified and hedged against underperformance of this sector.

Defensive of "risk off"
Healthcare, telcos, consumer staples, insurance
Aggressive, cyclical and "risk on"
Resources, mining services, construction, engineering, housebuilding, consumer discretionary, biotechnology
Leveraged financials - tend to be "risk on" too
Commercial banks, investment banks, asset managers, REITs

Note these correlations are not perfect and are a general guide only. For example, sometimes commercial banks like the Big Four are seen as defensive and sometimes as leveraged to the economy. We strongly favour the latter view.

Investors with the resources, experience and maturity to cope with strong portfolio volatility can consider more concentrated exposure to correlated stocks, especially if these are bought when deeply undervalued.

In general inexperienced investors should prefer undervalued companies with established, proven business models, a record of recurring earnings and dividends, conservative balance sheets, and competent, ethical and shareholder focused management and directors. All investors should prefer such companies but more experienced and diversified investors can also consider earlier-stage business models, turnarounds and special situations.

Selling, rebalancing and staying diversified over time

Diversification of equities through initial purchases of securities is not enough. You shouldn’t fire and forget in the sharemarket.

As an astute investor, you need to watch each of your companies like a hawk, closely monitor your portfolio, take profits in overvalued stocks and reduce weightings to target percentages. Check your portfolio at least weekly for holdings which have risen above 10%, or whichever upper limit you choose, of the total.

Understanding selling is crucial to managing your risks. Intellectually and emotionally, selling is much harder than buying. When a stock rallies, the media and broker reports are full of reasons why the earnings growth driving the rally can go on forever. It becomes easy to justify progressively higher valuations. The investor feels pressure to hold on – to not miss out on further appreciation and also likes the confidence boost from owning a stock going up. The temptation to tell others of one’s success and bask in the resulting congratulations can be irresistible. Overconfidence and self-attribution biases creep in.

This is where successful investors really differentiate themselves. Successful value investors have rules for selling which typically lock in their required rate of return while ‘leaving some on the table’ for the next buyer.

“Always remember the goal is an adequate return, not to be greedy.”

Consistently buy and sell like this and you will actually end up streets ahead of the average investor. You will also avoid the heartbreak of holding on past the end of a wonderful rally only to see a stock collapse to what you paid for it or worse. This happens. Very few stocks rally steadily for more than five to six years and usually by this time, so much optimism is priced in that even a small disappointment can trigger a 30 – 40% fall. Learn to sell when the market prices is a scenario better than your bull case.

Selling is also crucial to adequate diversification when your investments do not work out. Take it from us: the first cut is always the best cut. A fluctuation below your purchase price due to a correction in the market is one thing, but stocks rarely rally soon after a company-specific disappointment like an earnings downgrade where the disappointment means your thesis for buying the stock was wrong. Typically stocks which disappoint under-perform for months after the bad announcement and the first negative announcement is rarely the last. We know how painful it is to crystallise a loss soon after buying in hope, but this pain pales against the agony of seeing your stock trend ever lower below your purchase price.

If you think the disappointment is no more than short-term noise then by all means hold on. But when your initial case for owning the stock is proved wrong, sell early and you will most likely still have 60 – 90% of your capital. You can always buy back into the same stock later, when it is likely to be cheaper, or you can invest the capital in other opportunities.

Read more about Value Investing | Portfolio Diversification & Risk Management

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