11/18/2009

Is Diversification Necessary? If so, how much?

It is generally, and overwhelmingly, accepted that the diversification is essential for an investor to reduce risk. I, more or less, agree.

Simply put, if I understand the businesses well, I only need a small amount of diversification. If I don’t understand the businesses and am uncertain, I need an intensive amount of diversification.

One thing to note is, however, that investment failures are costly, but inevitable parts of investing even for a few highly intelligent investors just as in the case where an even excellent corporation can’t avoid a number of costly failures in their R&D to come up with a super hit product. Therefore, a modest amount of diversification is necessary for unexpected surprises in your investment. Then how much diversification is needed? In investment class, students learn that a portfolio has undiversifiable systematic risk and diversifiable unsystematic risk, and investors should only bear systematic risk which can’t be diversified away. I disagree. From my perspective, historical price performance tells you a little to none about future price performance. Therefore, a portfolio that bears only systematic risk, calculated from its historical price, will inevitably have unsystematic risk in the future.

Then what is the appropriate way to diversify your portfolio?  I would say it is different from people to people.  If you were CEO of a company and understand the company well, it would be unreasonable to buy many other companies that you don't understand just for the sake of diversification.  Since you know the intrinsic value, you can buy and sell if it deviates a lot from its intrinsic value.
In addition, the diversification should be different depending on which stock you buy.  If you buy a stock, say, Procter & Gamble or Berkshire Hathaway, then you have already done a fair amount of internal diversification since both of them own a number of companies from a number of different industries internally.  On the other hand, if you purchase a bunch of stocks in the same industry, it would not be enough diversification regardless of how many stocks you buy and what your portfolio beta is.

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