We have all heard the saying – Nobody should have all their eggs in one basket. Yet the recent property mania, the tech bubble at the start of the century and the stockmarket crash of October 1987 were clear reminders to people that they can do serious damage to their wealth if they get caught up in speculative frenzies. Every rational stock market investor should try to maximize their returns, but they should also try to minimize the risks of their portfolio. This article deals with the minimization of that risk by simple random diversification of an equity portfolio and talks about why you should diversify.
THE RISK OF HOLDING SECURITIES
Portfolio theory talks about two types of risk: Market Risk and Unsystematic Risk.
Market risk can be caused by political, social or economic factors. Under this heading come: Interest Rate Risk, which is the uncertainty of future markets and income due to fluctuations in the general level of interest rates; and Purchasing Power Risk, which occurs as people lose their purchasing power due to inflation.
Unsystematic Risk is unique to a firm or industry. It may be Business Risk, which relates to things like the operational efficiency of a firm; or Finance Risk, which is dependent on the capital structure of the firm.
Based on the Market Model, the “Rs”, being the return of a stock, can be divided into: “a”, the alpha; “b”, the beta; “Rm”, the market return; and “e”, the unexplained term or error. The equation is simply: Rs = a + (b * Rm) + e
The total variance or risk of holding this stock can be split into two parts: the variance of the part of the equation (b*Rm); and the variance of the error term. The former is the market or systematic risk. The later is the residual variance or unsystematic risk.
RANDOM PORTFOLO DIVERSIFICATION
If you create a series of random portfolios of different sizes, say 2, 5, 10, 15 and 20 stock portfolios and then calculate their correlation with the S&P 500 index, you will find that the correlation rises as the portfolio size increases. Therefore the overall risk or deviation from the market return decreases with the number of stocks.
Furthermore if you calculate the residual variances for each of these portfolios you will find that the unsystematic risk falls quite rapidly at first, as the portfolio size increases, but then tails off. In fact the results of such an exercise are consistent with Fama’s findings, which showed that it is unnecessary to purchase the whole market to diversify risk effectively. The rate of risk reduction is initially quite high, but flattens beyond 25-30 shares per portfolio.
TRADING AND DIVERSIFICATION
If you are trading it is important to diversify your portfolio as much as possible. It is true that the larger the portfolio, the harder it is to generate good ideas. Warren Buffett has emphasized this many times, but not everybody has a cash flow stream like he does, so it is all the more important for you to avoid panic selling of the holdings that you have and that you steer your portfolio like a large ship, which you should try to steer as calmly as possible though rough waters. Unrealized losses can always reverse back into profit, which means you have lost nothing. However, if you sell – you lose!
CONGLOMERATES AND COMPANY DIVERSIFICATION
There was a time that Conglomerates or Holding Companies were all the fashion. Eventually markets began to realize that the managers were not skilled in all the businesses they acquired, or in the countries they diversified into. They often had huge start-up costs with new ventures, or had to pay big premiums to do acquisitions from those in-the-know people, who were selling out. The tendency was more towards empire building than quality of earnings.
Buffett found his solution to this problem, by keeping on the management in the companies he bought. However, by simply buying shares of different companies in the market, you are diversifying earnings and keeping the management.
DIVERSIFICATION AND BUFFETT
There are many myths about Warren Buffett. Few realize that he does trade in Derivatives, and is right now hedging his equity position using puts on the equity indices, despite his attacks on the dangers of their usage. Not many people know that Buffett is one of the most astute bond traders on the planet, or that he has successfully traded in the Silver Market, or that he takes huge currency positions. He was also one of the first people to invest in a Chinese Oil company and was involved in the rescue of Salomon Brothers, although it was not his typical style of investment. The point I wish to make here is that those who say that the great money is made by holding a small collection of assets that you understand is nonsense.
Buffett’s investment success is not an argument against Diversification. Far from it! There is more to Buffett’s success then just a few companies. It takes 50 years of investment experience to get to be a Buffett. You do not get experience by holding a few stocks. Buffett knows the workings of very many industries and markets. Buffett’s success is also due in part to the country he was born in, the time he started investing and his early association with Benjamin Graham.
The other factor that is very important to note is that Buffett has used massive cash flows generated by insurance premiums from the Geico Corporation and his Reinsurance ventures to invest in equity markets during very long bull markets and times of unprecedented economic growth in the US economy. The average investor does not have the benefit of this infinite cash flow, which allows for perfect Dollar Cost Averaging. The typical investor has little money to invest in stocks when he is young, but can take more risk. Later in life he earns a lot more, but knows retirement is coming, so he is more risk averse. These factors are not relevant to Berkshire Hathaway, but they are to you and me and part of the solution is diversification.
CONCLUSION
The last word concerns Peter Lynch, who was made head of Fidelity’s Magellan Fund in 1977. When he started the fund was worth $18 million. When he finished managing the fund in 1990, it was worth $14 billion. The punch line is that Peter Lynch had up to 1500 stocks in his portfolio and it most certainly did not hurt his performance.