Diversification – Beyond % allocation

I started my venture into full time investment in early 2012 and since then read numerous books and articles and collected various investors’ thoughts on diversification. I think most of the amateur investors [including myself] think about diversification only in terms of percentage allocation to various stocks in the portfolio. I think it’s much beyond that. The level of diversification or concentration depends on lot of factors whether one is professional investor or amateur investor, whether one invest in wide moat growth stocks preferred like Warren Buffet or statistical cheap stocks preferred by Benjamin Graham or established blue chip companies or micro caps etc. Moreover one can protect the downside and add few % to one’s portfolio performance by allocating some portion of portfolio to special situations, cyclical companies which are currently facing cyclical downturn, turnaround situation etc. 

Portfolio concentration is not for everyone

Warren Buffet and Charlie Munger have popularised the concept of concentrated portfolios of 8-10 stocks. Concentrated portfolios might be good idea for professional and experienced investor but not for EVERYONE. Here I would repeat Howard Mark famous quote “In Vegas they say, “the more you bet, the more you win when you win.” Although the logic of this statement is impeccable, it omits the obvious addendum “. . . and the more you lose when you lose.”

Even Warren Buffet has made it very clear that concentrated portfolios are not for everyone. “I have two views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund, and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb. If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice.” [Source: http://buffettfaq.com/%5D

Level of correlation among various stocks in the portfolio 

Again many times it’s not the actual number of stocks in your portfolio which matters for diversification but what level of correlation they have, to your portfolio. Is the correlation is such which will expose you severely from any black swan event to an extent that you cannot recover.

Here are few pointers from “Common stocks and Uncommon profits” by Philip Fisher and these are equally important for people who believes in maintaining concentrated portfolio of 6-8 stocks and equally important for people like me who believe in maintaining portfolio of 15-20 stocks [with 5-7 themes which can be sector themes or growth vs cyclical theme or anything else]

1)      Nature of stock itself has a tremendous amount to do with the amount of diversification actually needed. Eg. A single product company entirely dependent on a single industry or a single product company with application in varying industries. A company with multiple products but whose fortunes are entirely dependent on one industry vs a company with multiple products with exposure to varying industries whose fortune not tied up at all.

2)      Cyclical industries whose fortune fluctuates sharply with changes in the state of business cycle – inherently require being balanced by some what greater diversification than do shares in lines less subject to this type of cyclical fluctuations.

3)      Investor with ten stocks with eight of them from banking is inadequate diversification and in contrast another investor with ten stocks from completely ten different industries may have more diversification than he really needs.

4)      When maintaining highly concentrated portfolio, ensure that there is no more than a moderate amount of overlapping, if any, between the product lines of his selected companies.

5)  Refer page no. 135 to 144 of his book for more detailed discussion in which he divided the total portfolio into three categories A, B and C and prescribed some % allocation.  In this Philip Fisher had made distinction between established blue chip companies, young but proven growth companies and emerging growth companies with possibility of losing 100% capital in case of unsuccessful companies. He had suggested allocation varying from 20% for established blue chip companies to 5% for emerging growth companies.

Betting big on best ideas 

I fully appreciate and understand that to make most of one’s conviction and in-depth analysis one should bet big on best ideas. Wonderful discussion supporting concentrated investing has happened here .  I think the entire debate is dependent on the investment approach one is following. If one wants to invest in “Wonderful companies at fair price like Buffet” then concentrated investing is the way to go as there are not many of such companies are available, but if one’s approach is to buy “fair companies at wonderful price like Tweedy and Browne partnership firm” then wide diversification is the way to go. For my straight equity position, I am more comfortable with Tweedy and Browne approach of restricting position in single stock to maximum of 3-5% as I invest in stocks which are cheap by PB and PE basis and try to avoid value traps. In simple words “How much diversification is enough: As much as, if that stock goes bankrupt it will not result in undue financial stress to you.” Here is what they have mentioned in their various letters to shareholders

“To minimize errors in analysis or events which could adversely affect intrinsic values, we adhere to a policy of broad diversification; with no one issue generally accounting for more than 3%, at cost, of the net assets of the portfolio and no industry accounting for more than 15%, at cost, of the net assets of the portfolio. Not only does diversification reduce risk, it also increases the probability through the workings of the law of large numbers that a return will be realized from the entire portfolio.”

“Some very successful money managers prefer to make larger, concentrated bets in fewer stocks. Our confidence in our abilities may not be as great as their confidence is in theirs. People should do what they feel comfortable doing. We feel comfortable diversifying to a degree others may feel is excessive. 

“Growth investing requires concentration and value investing requires broad diversification: Unlike growth stock investing, which may require a high degree of concentration given the small number of truly great businesses, value investing requires broad diversification. We cannot determine, on a stock by- stock basis, when a company will go from being undervalued to being fairly valued. Historical data will provide averages but the stock-by-stock variations can be dramatic.”

Diversification across market cap 

Ralph Wanger in his book “A Zebra in Lion Country” highlights the importance of  diversification across market cap. “For reason no one has satisfactorily explained, small-cap stocks go through cycles of investor favour. When people comment on the health of ‘the market’ they mean the Dow Jones Industrial or the S&P 500 Index. The chart of the patient in the next bed – that is small stocks may look quite different. There are really two distinct markets, and their fortunes alternate.” Below is the table of S&P 500 index.

Period Large cap Small cap
1963-68 Underperform Outperform
1969-74 Outperform Underperform
1974-88 Underperform Outperform
1983-1990 Outperform Underperform

Sure, you can pick small cap stocks that do well no matter what style is in vogue, but it’s harder when you have to swim against the tide. And you are more likely to be faithful to a fickle market if you are getting satisfaction from some part of your portfolio at all times. Style diversification, too, is smart policy.”

Special situations

Professor Sanjay Bakshi has re-iterated the importance of investing in risk arbitrage situations (special situations like rights issue, demerger, spin offs, delisting etc) on his blog and presentations for earnings market neutral returns. I think this is one of the best way to earn market neutral returns and also ensure that 20-25% of cash is available for reinvestment to take advantage of big drop in market at short notice (but nevertheless it may take 3-6 months to completely dilute one’s exposure to special situations).

Time, Sector and stage diversification 

Bala Deshpande, Managing Director of New Enterprise Associates, in her interview in Entrepreneurial magazine, January 2013 provides a good framework on how to manage risk under current uncertainty. “The biggest thing about venture capital is we are placing our hopes on future events which in today’s world are very unpredictable. The way to address that is to be systematic in your portfolio construct, which is really sector diversification, stage diversification [for listed companies I think we can interpret it as diversification across Micro-caps, Small Caps, Mid-caps and Large caps] and time diversification.” [During the interview she mentioned that ‘ In 2008 trends change significantly and that’s when we picked up few assets.  I think she is stressing importance of keeping cash balance to take advantage of any significant change in market trends]

Spreading your money among several categories of stocks 

Peter Lynch  in his book “One up on the Wall Street” insist on exposure to stocks from various categories

Some people ascribe my success to my having specialized in growth stocks. But that’s only partly accurate. I never put more than 30– 40% of my fund’s assets into growth stocks. The rest I spread out among the other categories described in this book. I’m constantly looking for values in all areas, and if I find more opportunities in turnarounds than in fast-growth companies, then I’ll end up owning a higher percentage of turnarounds.”

Categories Risk Possible return Allocation
Slow Growers low Low return (div yield) 10-20%
Asset Plays low -10% to 5x Balance
Cyclicals High/low -90% to 10x, depending up timing the cycle 10-20%
Turnarounds High -100% to 10x Balance
Fast growers High -100% to 10x 30-40%
Stalwarts Moderate -20% to 50% Balance

Note: I made the above table based on the discussion in the book

Out of money put options 

 Mohamed El-Erian, CEO and co-CIO of PIMCO,  says “People used to think that diversification was good enough, but no more. Diversification is necessary for any investor but it is not sufficient when central banks have distorted prices.”  He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you’ll need it.” He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.

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7 Responses to Diversification – Beyond % allocation

  1. Vidyanshu says:

    Very nice article Anil. Some thoughts – how frequently would you review your portfolio and what would be your sell policy. Would you use something like kelly criterion to decide your allocation policy? Would you use external imposition like half stocks half special and then not more than 1/3 for any opportunity?
    Vidyanshu.

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    • anil1820 says:

      Thanks Vidyanshu

      Yes, I allocated around 50% to special situations, but currently its much higher than this. I liked various special situations bet which I came across. Currently I do not have any strict overall limit for special situations as I have decided to invest my full position for equity over next 4-5 years. I do not follow Kelly criterion in its full form but I follow two rules for special situations (i) the larger the expected return, the bigger the position should be, and (ii) the larger the possible range of outcomes, the smaller the position should be. In special situation I go upto 10-12% if downside is absolutely protected. For straight equity still limits to 3-5%. Having said that, my capital allocation is still evolving and many times I fail to follow my own rules.

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  6. Reblogged this on drnaveenblog and commented:
    very good article on portfolio construction

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