My Take on Diversification and Risk
I’ve always said over diversification is bad for your financial health, and taking more risk does not equal higher returns. I know this goes against conventional wisdom, but it’s still true. The Globe and Mail recently printed a great article (view PDF) on diversification and risk which agrees with what we (value investors) have been saying all along.
You can read the complete article here, but I’d like to share some of the highlights with you. George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario. Mr. Athanassakos writes:
Value investors have concentrated portfolios, not because they reject diversification, but rather because they operate within the boundaries of their competence; they select only securities they understand; they prefer companies with stable cash flows and a history of steady earnings that can be reliably valued.
“The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about,” Keynes wrote. And Gerald Loeb, co-founder of E. F. Hutton, wrote in his 1935 book on The Battle for Investments Survival, “Once you attain competence, diversification is undesirable.”
Generally most value investors have a stock portfolio of about 15-30 stocks, any more than that and their returns will start declining (and start matching market returns). Index funds and ETFs hold anywhere from a few hundred stocks to a few thousand. Think about that for a moment, with that many stocks you are guaranteed to hold “loser” (poor quality) stocks.
Conventional wisdom states that the higher the volatility of a stock the higher the risk, again this is not necessarily true, Mr. Athanassakos continues:
Finance academics define risk as volatility or its derivative, beta. But is beta relevant? Is beta an appropriate measure of risk? TD Waterhouse reports that Intel Corp.’s beta is 0.88, while Sierra Wireless beta is 0.66. Based on beta, Intel is a riskier company than Sierra Wireless. But does anyone believe this? For value investors, volatility is not an appropriate measure of risk. Value investors see risk as the probability that adverse outcomes in the future will permanently impair the business’s potential cash flow and investor’s capital.
What then is really important for value investors? What do we look for when deciding what to invest in? Mr. Athanassakos concludes:
What is material for value investors is whether a company continues to have strong long-term prospects and fundamentals, be well managed and financially sound, as well as “cheap” – that is, its stock price is significantly below the intrinsic value (by a predetermined margin of safety). Value investors want to ascertain that a company has the ability, financial and operational, to withstand adverse states of the world and “sustain pain.”
I personally use the 12 Rules of Simply Investing to ensure that I am investing in a company that is well managed, financially sound, and undervalued (cheap). After 17+ years I see no reason to invest any differently, regardless of what conventional wisdom thinks.
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