January 18, 2017    4 minute read

Portfolio Diversification: Bane or Blessing?

Sound Strategies    January 18, 2017    4 minute read

Portfolio Diversification: Bane or Blessing?

In forming an investment strategy, one fundamental question comes to mind: how much should one diversify? As counterintuitive as it may sound, a vast majority of individual investors have extremely concentrated portfolios. Given that owning a house in most cases is at the top of an individual’s bucket list, for example, real estate typically ends up taking over 50% of a homeowner’s asset base. One can diversify all one wants, but the benefits of this will seldom be realised due to the already existing real estate bent.

To Vary or Not to Vary

On the other hand, if one sees a share of stock as an ownership interest in the underlying business concerned, then owning a portfolio of ten stocks is equivalent to being a part-time owner in ten different businesses. After all, as a shareholder, one gets to participate in the company’s profits in the form of capital gains and dividends and to also have a say in its matters by exercising proxy votes.

If each of these businesses happened to be in non-related sectors of the economy, then the portfolio would have attained reasonable diversification without negatively affecting the upside. For example, the factors affecting Apple are different from those affecting ExxonMobil, as evidenced by their behaviour during the financial crisis as well as the recent oil price collapse.

Individuals making a living by running their own businesses are completely invested in their respective ventures. Not only does a huge chunk of their net worth get locked in pursuing such endeavours, but a lot of individuals also take on debt and are thus highly leveraged. An 80% portfolio allocation towards equities of eight to ten companies involved in diverse businesses looks innocuous in comparison.

According to Modern Portfolio Theory, investors should allocate between a risk-free asset and a risky one, the latter being their market portfolio. On paper, it might sound like a great way of attaining the highest return for a given level of risk, but in reality, it is next to impossible to replicate it, especially when trading fees and commissions are factored in, as it is not realistic to own every listed security – which is what the market portfolio is supposed to represent. A good proxy for the market is the S&P 500 index, which represents around 80% of total available market capitalization. In doing so, however, one misses out on countless individual securities with significantly better performances and better insulation from macroeconomic factors.

Lessons for Investing

What, then, should an individual investor do in order to achieve satisfactory results in the market? Investing in fixed income instruments puts a cap on the maximum attainable returns and does a poor job at keeping up with inflation. It is great for wealth preservation, but not for wealth creation. Some forms of investment like venture capital and private equity are out of reach for most individual investors. Alternative instruments like real estate make a portfolio too concentrated, and do also have the drawbacks of lack of liquidity, portability, and the like.

Equities, on the other hand, come in more flavours than one can imagine if differentiated by sector and business models. Not all businesses are made alike, and some are more resilient during recessionary times than others, with a select few robust companies actually flourishing during such times. They have unlimited upside, are fungible, liquid, can be easily priced (since stock prices are available by the second), and tend to keep up with inflation.

Investing in real estate directly would be a demanding endeavour, but investing in a Real Estate Investment Trust (REIT) exposes the shareholder to cash flows similar to those from renting property, thus preserving the upside of real estate without the downsides listed in the previous paragraph.

Long-Term Goals

It is thus evident that investing in equities is an ideal way to attain one’s long-term investment goals at the expense of the aforementioned average short-term volatility. Although allotting a bulk of one’s assets to equities is advisable, it would be unwise to own shares in just one company.

It is also not prudent to own more than 30 stocks, as the benefits of diversification will start putting a cap on the achievable returns. Anywhere between ten and 25 stocks is an ideal number to own – the lower, the better, but that depends on an individual’s risk tolerance, along with his or her familiarity towards and the conviction of the businesses owned. One could call this a concentrated portfolio, but in the long run, it will perform better than an over-diversified portfolio split equally between equities, fixed income, real estate and commodities.

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