Diversification & Risk

As I mentioned in my previous post, in general, a portfolio should not be so heavily concentrated in any one particular area of focus or industry sector. Even the best ideas can turn sour or stagnate for long periods of time, so it is imperative to use various diversification methods to manage risk.

That being said, it is also critical to not over-diversify.  The last thing you want to do is to hold so many different positions, across so many industries, that your portfolio is essentially its own index, mirroring the movement of the broader market. 

So if the goal of diversification is to minimize risk, then it might help to define “risk” itself…

Efficient market believers and academics often equate risk to relative volatility: the probability that the diversified portfolio will move up or down at a greater rate than some index (like the S&P 500, for example). The efficient market hypothesis – the idea that the market always incorporates the best estimate of the true value of a security – is wholly embedded in this definition of risk and implies that it is impossible for someone to identify, act upon, and ultimately be rewarded for selecting undervalued stocks.

Value investors (and other active portfolio managers) disagree wholeheartedly.  They believe that a more accurate definition of risk is the potential for permanent loss of capital. Stock selection does matter and it is through this careful selection process that you can help diversify your portfolio, even while remaining relatively concentrated in your number of holdings and industry focus.

So, a few preliminary tips for reducing portofolio risk through careful stock selection:

Operate within your boundaries of competence – by this I mean, only select stocks / companies that you feel you understand. Typically, value investors prefer companies that can be reliably valued, with stable positions, a history of sustained earnings, and businesses that are not vulnerable to sudden changes in technology or consumer taste. For example, I personally avoid sectors like healthcare / pharma where a) I have very limited prior knowledge, and b) individual companies are heavily influenced by both technological and researched-based advances, as well as outside (i.e. government) influence.

Requiring a margin of safety provides a mechanism for reducing risk that is totally distinct of diversification – buying a company for substantially less than tangible book value or the value of its earnings is already a low-risk strategy. Using an asset-centric valuation as a check on valuation based on earnings power – while refusing to pay up for growth prospects – further limits risk. Yes, this may mean restricting yourself from the glamorous, high-growth tech stocks that are so often discussed on CNBC. If a typical equity portfolio needs 20 or 30 names to be sufficiently diversified, then a margin of safety portfolio might only require 10 (or fewer).

Apart from merely diversifying through the number of holdings or the industry sectors represented, it is important to remember that finding assets that are unrelated (or even negatively correlated) to your other holdings is another way to diversify or hedge against downside risk. The classic expression of this idea is the portfolio consisting of an umbrella maker and a sunscreen manufacturer: a portfolio for all seasons.

Similarly, some investors take advantage of the low correlation between the broader market and event-driven instruments (i.e. arbitrage positions, takeover targets or spin-off companies, or even companies going through Chapter 11 bankruptcy or liquidation), where market fluctuations will have little effect on individual stocks. Here you will find distressed debt investors, looking to purchase heavily discounted debt obligations. Others still will diversify by investing in hard assets, like real estate, or decide to purchase ownership shares of entire companies – private equity firms and Berkshire Hathaway, for example, utilize this direct ownership method.

Finally, a few other things that you can do to tangibly lower risk in your equity portfolio:

  1. Continually challenge your own judgments – constantly review your analysis of a particular stock and look for credible ways to confirm your decision. For instance, two key verification indicators include: knowledgeable company insiders buying the securities despite prevailing market sentiment and highly respected / like-minded investors taking similar positions (you certainly won’t find me on the other side of a Buffett or Gabelli trade…). Finally, consider why “Amazing Opportunity X” has fallen into your lap and why haven’t other investors piled into it? Humbly review your valuation analysis thoroughly with fresh eyes and try to locate errors.
  2. Set position limits – limiting the amount of a portfolio that you will commit to a single security is another easy way to reduce risk. If a position appreciates above your set limits, that can be a signal to trim back by selling into strength. Limiting exposure in this way can be especially helpful if you are prone to emotional reactions to market activity (or greed, no offense). Conversely, if you set a floor limit (i.e. you will not purchase a security unless you are willing to buy enough of it so that it will represent 5% or even 10% of your entire portfolio) then you will force yourself to do the proper amount of analysis and think carefully about your decision, as opposed to short-cutting or doing lazy analysis under the cover of taking a small position. You’d be surprised, but when added up over time, these little losses can dramatically impact your returns.
  3. Hedge against broad market declines – as opposed to short selling (or “shorting”) an individual company – which requires a lot of capital, patience, and guts – some investors opt for a broader insurance policy by shorting (i.e. buying put options on) a market index, such as the S&P 500. This conservative approach will protect you when markets go south, but will also hinder you when things improve. In other words, it will make the good times not as good, but the bad times not as bad.
  4. Don’t be afraid to come off the field – when asked about markets being overpriced or a lack of quality investing opportunities, Warren Buffett frequently cites a baseball analogy: an investor can take pitches all day long and not have to swing because there are no strikes called in investing. For retail investors, many times it makes sense to simply “diversify into cash” and sit on the sidelines when markets get over their skis and valuations begin to soar. Don’t let anyone fool you: in investing, it is far better to miss out on a risky opportunity that ultimately creates huge profit, then to actually bet on something that ends up generating enormous losses. Put another way, no hedge fund manager was ever fired for missing out on a risky opportunity that ended up paying off…

Remember, you cannot diversify away all risk. No matter how much you hedge, you simply cannot account for everything – there will always be an inherent risk involved when investing. If you don’t know the story of Long-Term Capital Management – a hedge fund comprised of leading academics and renowned financial economists that was, at first, wildly successful before ultimately going belly up in the late 1990’s – then I highly suggest that you take a look at Roger Lowenstein’s book, “When Genius Failed”.  A sobering reminder of the dangers of hubris, no doubt.

More to come on my 2017 stock picks and valuation methods.  As always, please feel free to leave me comments or questions in the box below.


The Southern Capitalist

Greenwald, Bruce. Value Investing: From Graham to Buffett and Beyond. New Jersey: John Wiley & Sons, 2001. Print.

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