Diversification is either good for you or bad for you, depending on who you ask.
Warren Buffett, the legendary investor and businessman, once said that if you know what you’re doing, it makes little sense to diversify.
But Peter Lynch, a star mutual fund manager of the 1980s, had a different approach.
He believed that the more stocks you own, the better your chances of finding a winner. Lynch was famous for holding up to 1,400 stocks in his portfolio.
Here’s the surprise: they both achieved remarkable success, despite their opposing views.
So, what does this mean for you, the investor? Should you diversify, or not?
Diversification is not a number
For starters, diversification is not just about the number of stocks you own.
Buying a fund which tracks Singapore’s Straits Times Index (SGX: ^STI), for instance, will give you a stake in 30 stocks.
However, for every S$1,000 invested, around S$454 will go to Singapore’s three banks, namely DBS Group (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39) or OCBC and United Overseas Bank (SGX: U11) or UOB.
Another S$60 or so will be invested in Singapore’s largest telco, Singapore Telecommunication Limited (SGX: Z74) or Singtel.
In effect, more than half your money will be in these four stocks alone.
Hence, buying Singapore’s STI will not help you to diversify as much as you think.
In contrast, buying a single share of Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A) would net you a cornucopia of different companies.
There is a wide collection of billion-dollar businesses from the insurance, railroad (BNSF), and industrial (Lubrizol) sectors alongside smaller businesses such as See’s Candies (snacks), Brooks (running shoes) and Fruit of the Loom (undergarments).
And that’s not all.
Berkshire Hathaway also owns portfolio of stocks with huge positions in Apple (NASDAQ: AAPL) worth about US$155 billion, Bank of America (NYSE: BAC) at US$36.8 billion, American Express (NYSE: AXP) at almost US$34 billion and Coca-Cola (NYSE: KO) at nearly US$24 billion, to name a few.
Arguably, this single stock, Berkshire Hathaway, is at least as diversified, if not more, compared to a 30-stock index.
That said, business diversity does not guarantee safety.
Diversification at different levels
Convention wisdom says that diversification is about buying different businesses from unrelated industries or geographies.
This line of thinking can be useful, but it is not enough.
In the case of Berkshire Hathaway, Buffett makes most of the capital allocation decisions. He’s been great at it for a long time, but he’s 93 years old today.
He won’t be around forever.
So, even though Buffett’s holding company has a diverse range of businesses, he still plays a big part in generating superior returns for shareholders.
When he passes on, it’s hard to imagine anyone else doing it as well as he did.
To be sure, concentration risk is not limited to the management level alone; it can show up in different parts of a business too.
Size alone does not guarantee diversification.
Look at Apple, the iPhone maker.
The company is worth over US$2.6 trillion dollars but it relies on one contract manufacturer, Foxconn Technology (TSX: 2359), to make most of its products. And only one company, TSMC (NYSE: TSM), manufactures chips for the iPhone.
In turn, both TSMC and Foxconn rely on Apple for a significant part of their revenue.
The examples above illustrate how concentration risks can form at different levels of a business, including suppliers and customers.
Diversifying for the right reasons
As we delve deeper into diversification, we should not lose sight of its goal: to reduce risk.
This is where buying businesses from unrelated industries or geographies can go wrong. In fact, investors who diversify into areas where they lack expertise are taking more risk, not less.
It makes little sense to do so, says Lynch.
How well you know your stocks matters more than how many sectors or regions you spread your money across.
My preference?
I agree with Lynch. Diversify only if you want to boost your chances of finding more winning stocks in your portfolio.
Here is a point you shouldn’t miss: you should always be looking to learn more about new businesses and industries.
As you become more knowledgeable, you can grow your portfolio with more stocks you know well, but without exceeding your limits.
Remaining humble is key.
Knowing the limits of your knowledge in any new area is how you keep yourself in check. As author Carl Richards once said: risk is what’s left when you think you’ve thought of everything.
Diversifying over time
Never rush into investing in a new business or industry. Take your time to learn.
Here’s a simple rule of thumb to help you.
If you’ve been following a new company for a year, invest no more than one percent of your portfolio into the stock. If it’s five years, then up to five percent.
You can adjust the percentage to fit your risk appetite.
The point of this strategy is to have a reference point where you can match your risk level with your knowledge level.
Let me say it again: be humble with new stocks.
You never know everything in the business world. Things can change over time as industries and players grow and adapt.
This is where simplicity works best: a rule of thumb to keep yourself in check.
Finally, investing over time helps to spread your risk over years.
Don’t worry about starting small in a stock. A winning stock is only known in hindsight.
Here’s the point most people miss: if a stock is destined to be a winner, the stock price rise will happen over years, if not decades.
And guess what?
You will have plenty of time to add to that winning stock.
Get Smart: Concentration as an outcome
Here’s the final conundrum: the mark of a successful portfolio is a concentrated portfolio.
But how can that be?
Let’s say you invested $1,000 each into 10 stocks.
Each stock will make up a tenth of this $10,000 portfolio.
After five years, the first one skyrockets, increasing by 10 times and is worth $10,000, while the last one goes to zero. The other eight stocks stay the same at $1,000.
Do the math and you’ll end up with $18,000 in total.
The big difference is, the winning stock will comprise more than 55 per cent of the five-year old portfolio.
What more, because of its size, if the best-performing stock continues to do well, it will drive most of your returns in the future. The worst-performing stock, which went to zero, will fade away and have no further impact on your portfolio.
That’s a pretty good outcome, isn’t it?
As you diversify to find more winners, the best of them will naturally rise to the top — thereby concentrating your portfolio in the right set of winning stocks.
That’s more than any investor can wish for.
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Disclosure: Chin Hui Leong owns shares of Apple, Berkshire Hathaway, DBS Group, OCBC and UOB.
