Some thoughts on diversification

Should diversification be pursued; and if so, to what extent?

Just a while ago I attended a short finance course as part of my law firm’s internal training. To my surprise (and to the unsurprising indifference of my peers), portfolio theory was part of the syllabus. As the lovely Indian lady began to brainwash us with the universally accepted ideas on diversification, I was anxious to release my inner value investor and challenge the dogma taught in business schools. Unfortunately, I didn’t get a chance to do so– hence this brief article.

Diversification reduces risk by combining investments. It’s important to differentiate systematic (market) risk from unsystematic (company-related) risk. The elimination of systematic risk (e.g. by short selling index options) is generally ill-advised because the market have always and will always go up in the long term. The elimination of unsystematic risk is a good thing as it lets you take a smaller hit if one of your investments fail — i.e. the positive performance of some investments can offset the negative performance of others.

Okay, but how many holdings should I have?

The more company-related risk, the more stocks you should hold. A certain amount of diversification should always be pursued, but it’s hard to find the sweet-spot. You may decide to buy one company’s stock which goes bust for reasons unforeseen or you build a widely diversified equity holding which is like an index tracker. Neither of these is ideal.

My main portfolio consists of cheap, volatile and illiquid, low-cap businesses, mostly in emerging markets. If your buying these cigar butts, lack of diversification is a bad move. In a similar situation, a portfolio of 8-20 holdings in different markets and industries would suffice, but you know what they say – different strokes for different folks.

In summary, the minimum number of holdings will be based upon your portfolio’s unsystematic risk profile and the maximum will be limited by how many you can take the time to monitor. In any case, holding at least 5-10 investments with low correlation is what you should be aiming for, regardless of your strategy.