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Diversify—-Smersify June 18, 2010

Posted by shaferfinancial in Finance.
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One of investing idea’s that is generally taken as investment law is the idea of diversification.  Generally, it comes from the work of Eugene Fama on the efficient market hypothesis [EMH].  As usual something theoretical, and very specific has been turned into an unwritten rule of investing without much thought given to the original work.  In 1977, Elton and Gruber did seminal work on the question of financial risk reduction through diversification.  Diversification is a strategy to reduce variability, with the idea that by owning many investments you can offset loses with multiple winners.  Elton and Gruber figured out the expected variability for stock ownership.  For example, owning one stock has an average standard deviation [a measure of variability] of 49.2%.  Remember this number can be positive or negative, so you could expect to make 49% or lose 49%.  Owning 6 stocks drops the variability down to 26%.  10 stocks to 24%. 20 stocks to 21.7% and 30 stocks to 20.9%.  Note that going from 1 stock to 10 stocks reduces the variability almost 26% and moving from 10 to 30 stocks only reduces variability by 3%.  After owning 30 stocks the benefit largely goes away.  In fact 82% of the total benefit is received by owning only 6 stocks.

The question is why would I not want all the benefit by owning 30 stocks?  Well Buffett points out this conundrum a little differently.  He asks why you would want to own your 30th choice stock instead of your top choice?  The point is that as you study companies in which to buy, you are going to make a list on which one’s you think are the best.  Why take a chance on lower rated stocks instead of owning more of your higher rated stocks?  Underlying this is the issue of diversifying away your chances of having a high performance portfolio.  Remember the variation reduction was on both sides of the curve [positive and negative] so you are reducing your expected return in a trade-off of reduced risk of large losses.

Now, of course, diversification as it was originally designed had to do with owning different types/areas of investments.  The theory is real estate and stocks were not highly correlated so by owning both your overall portfolio would not drop all at once.  But recent events point out that there is some overall correlation within different asset classes.

As typical in the finance world, what is best for the consumer takes a back seat to what is best for the sales person.  By suggesting highly diversified portfolios and/or highly diversified ETFs/Mutual Funds, the sales person is merely covering their behind in case of lawsuits.

Here is the take away, for every additional stock you purchase, ask yourself if the reduction in variation is worth choosing that stock.  For me, owning 3 or 4 stocks, and having the majority of the benefit of variation reduction [66% for 4] is were I am comfortable.  For you it might be owning 6 or even 12 stocks.  But beyond that, can you really keep up with those 13,15,20 companies in an in-depth manner?  If you can’t then you are taking on more risk, even is the theory says you are reducing risk/variation.



1. investmentblogger - August 9, 2010

Great explanation Dave. Its simply amazing how many people still consider diversification as a key “law” in investing!

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