Monday, 20 February 2012

Appropriate Diversification

Even relatively safe investments entail some probability, however small, of downside risk.  The deleterious effects of such improbable events can best be mitigated through prudent diversification.

The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great, as few as ten to fifteen different holdings usually suffice.

Diversification for its own sake is not sensible.

  • This is the index fund mentality if you can't beat the market, be the market.  
  • Advocates of extreme diversification - which I think of as over-diversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great.  
  • My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings.  One's very best ideas are likely to generate higher returns from a given level of risk than one's hundredth or thousandth best idea.

Diversification is potentially a Trojan horse.

  • Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk.  Investors who believed them substituted diversity for analysis and, what's worse, for judgment.  
  • The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little,  is highly risky.  
  • Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction.  
Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.

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