Tuesday, October 04, 2005

The case for diversification 2 comments

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It is interesting to note that most academics toe the same line on the benefits of diversification, while the most famous and successful investors, people like Warren Buffett and George Soros typically make mega-bets and do not generally believe in spreading the jam too thin. This is understandable; the former's beliefs are a function of their academic grounding in CAPM and Efficient Market Hypothesis (whose corollary would of course be that it would be wise not to depend on one's luck and random events), while I believe the latter's can be attributed to their strong understanding of the investment industry imparting a deep confidence in their stock picks.

Small investors feel the urge to put their eggs in one basket all the time. One may, for example, have put some money into SPC, watched it jump from 4 to 6 these past few months, and wished that he had put all his money into it. This is a very tempting thought; imagine your net worth rising by 50% within half a year. However, one has to realise it is human nature to think about the bright side of things; one could just as easily have put his money into ACCS or Citiraya and watched his net worth melt away.

My belief is that diversification is a strong risk management tool if employed only in relevant situations. Typically, the impetus behind a stock's price run can be attributed to three driving forces: the market, the sector and the company itself, in roughly equal proportions. One must question what is one's reason for buying a certain stock: is it that this particular stock is uniquely undervalued (a company factor), or that one is optimistic on the particular industry (a sector factor), or simply because one is bullish on the market and hence chooses to pick a high-beta stock which might rally the most (a market factor). The choice for diversification varies in each case.

If it is a company-specific factor, it makes sense to concentrate the ammunition on the particular company, and diversification doesn't make sense since the investment advantage is to be found only within this particular company. Of course, one has to be pretty confident on the company. Usually, in such cases a substantial margin of safety should be the first thing to look out for, such as P/NTA<<1.

It gets interesting for a sector-specific bet. If one is buying a stock mainly for the reason of getting into a hot sector (such as oil & gas or property nowadays) then surely one perceives the investment advantage to be the sector long-term fundamentals, in which case it makes sense to diversify through purchasing other similar companies in the same sector (provided they are not overvalued). Quite often there is more than one company in that sector that looks attractive valuation-wise; splitting funds into these sector peers seems like a logical move. In this way, one diversifies away company-specific risk (such as management dishonesty) but still captures potential rewards from any re-ratings of the sector. In statistics-speak, the standard deviation (risk) is lowered while mean returns remain the same, compared to if one put his money on only one particular sector stock.

Lastly, if one is investing mainly because one is bullish on the market, it becomes an asset allocation issue, involving a shift from cash to stocks. Under this scenario, he might as well put his money in an index fund, which involves very low fees compared to unit trusts, while offering the full benefits of diversifying away company-specific and sector-specific risk.




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