Diversification

Fund managers, Research Analysts and Financial Planners constantly talk about the importance of diversification, yet is the concept really truly understood?

The principals of diversification are utilized to eliminate what is commonly called concentration risk. Essentially this can be easily described as if you own one investment and this investment goes down in value or dissipates then you would lose everything. Holdings a basket of investments helps spread the risk. The questions become how many investments do you really need to be truly diversified?

What is commonly not know is that in reality to achieve 90% of the maximum benefit of diversification a portfolio only needs to hold between 12 to 18 shares. This is assumed that you own an equally weighted portfolio and the shares are not all in one asset classes. By holding more shares than this set amount in reality you will only be provided with an incremental benefit.

This principal of diversification is in stark contrast to the funds management industry which broadly hold 100’s of shares in their portfolio. You might to start to question if they only need 12 to 18 shares why they hold so many, are they trying to perform our just outperform the index. Keeping in mind if the index is negative -20% and they do -15% they have outperformed.

Warren Buffet in financial terms is regarded as one of the most successful investors. If one investigates the past 25 years you might be interested to find that his top 5 holdings on average comprise of 73% of this portfolio. Buffet has also been quoted in stating that “diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”

This is really in stark contrast to the funds management industry which actively promotes diversification across not only asset classes but within the funds themselves which are heavily diversified. So in reality are you getting any direct benefit of diversifying your portfolio or would an index holding suffice?

In business successful entrepreneurs stick within their areas of expertise and focus on building their knowledge and skill within this field to create their financial success. Warren Buffet also talks at great lengths about his investing within your circle of competence and when you look at his portfolio as listed above it is highly concentrated and also within specific sectors as opposed to being nicely spread across the market. 

If the above principals hold true then one also needs to start questioning the asset classes which one invests within such as cash, fixed interest, shares both locally and internationally, property including commercial property.   It would then also be appropriate to question if the sector makes financial sense in that is the sector overpriced or underpriced and secondly if you feel comfortable about investing within this sector. Too often people invest in sectors just for the underlying basis of diversification rather than looking for a return on capital for the risk which they are taking on with their portfolios. So make sure you are not diversifying your performance away.