Is Diversification A Good Thing?

Foreword from ShareInvestor

This article “Is Diversification A Good Thing?” by Cai HaoXiang was first published in The Business Times on 18 Feb 2013 and is reproduced in this blog in its entirety.

Maintaining a reasonably varied portfolio helps you minimise risk, so you won’t lose sleep over keeping all your eggs in one basket, writes CAI HAOXIANG

IMAGINE yourself being a proud shareholder of what used to be the fourth-largest investment bank in the United States – Lehman Brothers. You believed in the company so much that it was the only thing you invested in.

Listed on the New York Stock Exchange in 1994 for an effective price of around US$5 per share, the company’s share price soared steadily over the years to a high of about US$86 on February 2007, a return of about 17 times on one’s original investment.

You would be congratulating yourself. Lehman had made a smart move, it seemed then, by effectively lending money to house buyers amid a US housing boom.

Then, the subprime mortgage crisis hit. Many people could not pay their mortgages, leading to defaults. Lehman had borrowed too much to invest in and had underwritten low-quality mortgage-backed securities. It was in debt to the tune of US$600 billion.

Investors bailed. Creditors did not want to lend to the firm any more.

Lehman’s stock was at US$65 at the end of 2007. Three months later, it was trading at US$38. Another three months, and it was at US$20.

On Sept 15, 2008, the firm declared bankruptcy. By the end of 2008, Lehman stock was trading at 3 US cents.

Having only a Lehman-like stock in one’s investment portfolio, and having that stock turn out to be a dud or a scam, should rightly be a stock investor’s greatest nightmare.

There are other examples. Some employees of former energy giant Enron had put their life savings in the company’s stock before it went bust in 2001 due to fraud.

Closer to home, Citiraya Industries, a recycler of electronic waste, was once a stock market darling and highly rated by analysts. Then, the Corrupt Practices Investigation Bureau started investigating the company for fraud and bribery in 2005.

Its share price plunged to near zero. The firm was restructured and was known as Centillion Environment & Recycling, and now Metech International.

The idiom, “don’t put all your eggs in one basket”, is thus often cited as an investment adage. If you accidentally drop that basket, you might lose everything you pinned your hopes on.

Reducing Risk

Spreading one’s investments out thus has intuitive appeal. If you own 10 companies, the chances are probably not as high that all 10 will go bankrupt or suffer from accounting fraud. One’s risks of losing it all in a catastrophe are lower the more diversified one’s investments are.

In finance textbooks, risk is quantified as standard deviation – the extent that stock prices fluctuate around their mean in a given time period.

If one has a stock with a higher risk and higher return, together with a stock with lower risk and lower return, the return of the two-stock portfolio will be somewhere in between the returns of the two stocks.

But as long as the two stocks do not move up or down together all the time – meaning they are not perfectly correlated with each other – this portfolio will have less volatility. The portfolio often has a lower standard deviation than the standard deviation of either stock.

In short, diversification makes you sleep more soundly at night, knowing that the two stocks you have are not likely to suffer the extreme swings having only one or the other would.

Your returns will not be as good as your best-performing stock, but that is what you sacrifice for lesser volatility.

For a diversification strategy to work well, the investments one picks must not be correlated closely with each other.

This means that when stock A is performing well, stock B should not perform as well, and vice versa.

One can diversify across different companies in the same sector, different companies in different sectors, and even companies operating in different countries.

Some stocks tend to do well when others do not. A classic differentiation is between cyclical stocks and non-cyclical ones.

Cyclical stocks refer to ownership in companies that sell products that consumers can afford to buy more of when the economy is doing well. These include cars, air travel and luxury goods. When things are going well, earnings of these companies will go up, and when there is a recession, they might even go bust due to a lack of demand.

Companies which operate in non-cyclical, or counter-cyclical industries are those selling consumer staples like basic food, public transport, toothpaste, soap, and even tobacco. People are not likely to stop buying these products during a recession.

These stocks are also called defensive stocks. They are likely to be more stable and produce more consistent earnings – though their earnings will not shoot up when times are good.

Another distinction is between small company stocks and large company stocks. Historically, small company stocks have had the highest risk, but the best returns.

Diversify Across Asset Classes

Diversification does not stop within stocks. Rather, one can treat stocks as just one asset among many: bonds, gold, real estate, and even just cash.

Cash has the lowest return now in this low interest rate environment. It should theoretically be zero risk, but that is not the case in a high-inflation situation where money stashed in the bank can buy progressively fewer goods over time.

A distinction is often made between stocks and bonds. When the economy is roaring, stocks do well as company earnings soar. When times are bad, investors prefer the steady stream of predictable interest payments that holding bonds provide. This causes bond prices to rise, in addition to the half-yearly coupon payments that they would pay out.

Gold can also be a hedge against financial crises. When holding money loses its appeal, investors like to seek refuge in what they perceive as a physical store of value.

A recent SGX market update noted that in 2011, the Straits Times Index exchange-traded fund was down 14.1 per cent. By contrast, a fund proxy for the price of gold, SPDR Gold Shares, was up 12.3 per cent.

In 2012, markets roared back to life and the STI ETF returned 22.2 per cent. But SPDR Gold Shares was down 0.8 per cent.

Perils Of Over-Diversification

Diversification has a limit, however. One argument against too much diversification comes from recent history.

In the last few years, stock markets around the world have moved together in response to macroeconomic and geopolitical events.

If Greece looked like it was heading towards bankruptcy, every stock will fall, whether it is a high-quality oil and gas company, or food producer.

Once the US Federal Reserve announces it will pump in more liquidity into financial markets, most stocks will go up.

The lack of advantage that stockpickers had drove many hedge funds out of business.

A second objection to diversification comes from investment guru Warren Buffett in a 1966 report to Berkshire Hathaway shareholders, when he attacked investment managers for having too many stocks in their portfolios.

“We diversify substantially less than most investment operations,” he noted. “We might invest up to 40 per cent of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

His argument was like this: If he has worked so hard to find those special few investments that will outperform the benchmark Dow Jones Industrial Average, it does not make sense to put money in stocks that have a lower probability of performing as well.

Mr Buffett had a few choice words for those who had portfolios of 100 stocks. He called those managers followers of the “Noah School of Investing”.

“Two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles,” he said.

Mr Buffett was thus willing to sacrifice the risks of volatility – his investments performing badly in a particular year – in return for superior returns in the long run.

To make his point, he quoted Broadway showman Billy Rose, whom he called “that eminent academician”: “You’ve got a harem of 70 girls; you don’t get to know any of them very well.”

Or as humorist Mark Twain put it: “Put all your eggs in one basket – and watch that basket!”