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To diversify or not to diversify 
In March 1952 an article appeared in the Journal of Finance entitled “Portfolio Selection” by Harry Markowitz, a University of Chicago graduate. Markowitz’s thinking, which was considerably developed and simplified over the next decade by a PhD student named Bill Sharpe, introduced the core concept that risk and return are inextricably linked for an investor, i.e. you cannot achieve above-average gains without assuming above-average risk.
Over a decade after Markowitz’s original article was published, Sharpe developed a far-reaching concept called the Capital Asset Pricing Model (CAPM). According to CAPM, assets carry two distinct risks, systematic or market risk and unsystematic or specific risk. A keystone of the theory is that systematic risk is rewarded because, in the long run, investors expect compensation for bearing risk that they cannot diversify away. Such risk is inherent in the economic system and may relate, for example, to real business activity or to inflation. Unsystematic risk is the risk specific to a company’s economic position and the theory holds that investors are not rewarded for assuming this risk as it can be diversified away by simply adding different assets to the portfolio, with the diversification benefits of each additional asset added to the portfolio being inversely related to their correlation with the assets already held in the portfolio.
Diversification strategies
The diversification logic of the CAPM has so profoundly influenced investment analysis and portfolio management that the cornerstone of every conventional investment portfolio, whether private or institutional, is now that it should be sufficiently diversified to remove, or reduce to a manageable level, the specific risk associated with an individual stock or issuer.
This remains the case despite the fact that in the major stock market of the world (i.e. the S&P 500), a diversified portfolio would have yielded a negative nominal return over the last 10 years, while certain focused strategies would have performed exceptionally well over the same period. Indeed, to justify the benefits of diversification it is necessary to look at the markets over the long-term, say 25 years. Over this kind of period very few managers or funds have managed to outperform a diversified index, which seems to demonstrate that, over time, the ultimate diversified portfolio (the index) is indeed the best investment.
There are a number of strategies that investors can follow to achieve diversification; you can diversify across asset categories, within an asset category, and outside of your home country.
Diversifying across asset categories – Asset Allocation, i.e. the allocation of your portfolio across major assets classes such as stocks, bonds, cash and real estate, can be used to obtain your desired exposure to different systematic risk factors, e.g. you may decide to be underweight in bonds if you expect a period of high inflation in the future.
Diversifying within an asset category - By diversifying within asset categories, an investor can help reduce or remove the impact of a specific underperforming security. You could do this by purchasing many bonds, for example a portfolio consisting of long term, short term, government, corporate and possibly high yield debt would lower or eliminate (depending on the correlations) the risk of underperformance by a specific sub-sector or issuer.
Diversifying outside home country - Diversification can also help reduce the impact if home country financial markets were to suffer an extended bear market. While global investing includes additional risks, such as currency fluctuations and political uncertainty, diversifying outside of your home country can help offset overall portfolio volatility.
The Buffett Way
Warren Buffett, widely regarded as the world’s best investor (and alternating richest man in the world with Bill Gates) does not share the Markowitz / Sharpe view on the benefits of diversification. In the book The Warren Buffett Portfolio (Robert Hagstrom, 1999), he is quoted as follows:
Buffett and his partner Charlie Munger operated their investment partnerships mostly with 5 significant positions. The typical portfolio composition would be to have 80% in 5 positions, with 25% for the largest. Buffett is quoted as saying that “In 1964 I found a position I was willing to go heavier into, up to 40%. There were various times I would have gone up to 75%, even in the past few years. If it's your game and you really know your business, you can load up. Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position.”
Conclusions
While the elegant mathematical logic of the CAPM demonstrates the benefits of diversification clearly, it must be remembered that the model is theoretical and its reliance on statistical measures of risk (i.e. volatility) can be highly misleading.
Indeed, while few would argue against the benefits of some diversification, empirical evidence demonstrates that, in both the short and the medium-term (1-10 years), returns are generated by investors with superior information and / or a superior investment strategy. Under the CAPM theory, the strategies employed by John Paulson (high conviction calls like shorting the US housing market in 2007 and now buying gold stocks) are highly inappropriate due to their significant concentration and volatility. However it seems nonsensical for a manager who consistently generates major outperformance to be regarded as “high risk”.
We would argue that, for a professional (or highly skilled) investor with confidence, it is difficult to see why concentration should not be as appropriate a strategy as it is for Warren Buffett. However for everyone else, (e.g. part time or novice investors), it is advisable to participate in extensive diversification (i.e. buy the index). Just make sure you don't buy at the wrong price or at the wrong time. To quote Warren Buffett one last time, “if you try to be just a little bit smart, spending an hour a week investing, you're liable to be really dumb.”
In March 1952 an article appeared in the Journal of Finance entitled “Portfolio Selection” by Harry Markowitz, a University of Chicago graduate. Markowitz’s thinking, which was considerably developed and simplified over the next decade by a PhD student named Bill Sharpe, introduced the core concept that risk and return are inextricably linked for an investor, i.e. you cannot achieve above-average gains without assuming above-average risk. Over a decade after Markowitz’s original article was published, Sharpe developed a far-reaching concept called the Capital Asset Pricing Model (CAPM). According to CAPM, assets carry two distinct risks, systematic or market risk and unsystematic or specific risk. A keystone of the theory is that systematic risk is rewarded because, in the long run, investors expect compensation for bearing risk that they cannot diversify away. Such risk is inherent in the economic system and may relate, for example, to real business activity or to inflation. Unsystematic risk is the risk specific to a company’s economic position and the theory holds that investors are not rewarded for assuming this risk as it can be diversified away by simply adding different assets to the portfolio, with the diversification benefits of each additional asset added to the portfolio being inversely related to their correlation with the assets already held in the portfolio.
Diversification strategies
The diversification logic of the CAPM has so profoundly influenced investment analysis and portfolio management that the cornerstone of every conventional investment portfolio, whether private or institutional, is now that it should be sufficiently diversified to remove, or reduce to a manageable level, the specific risk associated with an individual stock or issuer.
This remains the case despite the fact that in the major stock market of the world (i.e. the S&P 500), a diversified portfolio would have yielded a negative nominal return over the last 10 years, while certain focused strategies would have performed exceptionally well over the same period. Indeed, to justify the benefits of diversification it is necessary to look at the markets over the long-term, say 25 years. Over this kind of period very few managers or funds have managed to outperform a diversified index, which seems to demonstrate that, over time, the ultimate diversified portfolio (the index) is indeed the best investment.
There are a number of strategies that investors can follow to achieve diversification; you can diversify across asset categories, within an asset category, and outside of your home country.
Diversifying across asset categories – Asset Allocation, i.e. the allocation of your portfolio across major assets classes such as stocks, bonds, cash and real estate, can be used to obtain your desired exposure to different systematic risk factors, e.g. you may decide to be underweight in bonds if you expect a period of high inflation in the future.
Diversifying within an asset category - By diversifying within asset categories, an investor can help reduce or remove the impact of a specific underperforming security. You could do this by purchasing many bonds, for example a portfolio consisting of long term, short term, government, corporate and possibly high yield debt would lower or eliminate (depending on the correlations) the risk of underperformance by a specific sub-sector or issuer.
Diversifying outside home country - Diversification can also help reduce the impact if home country financial markets were to suffer an extended bear market. While global investing includes additional risks, such as currency fluctuations and political uncertainty, diversifying outside of your home country can help offset overall portfolio volatility.
The Buffett Way
Warren Buffett, widely regarded as the world’s best investor (and alternating richest man in the world with Bill Gates) does not share the Markowitz / Sharpe view on the benefits of diversification. In the book The Warren Buffett Portfolio (Robert Hagstrom, 1999), he is quoted as follows:
“The strategy we’ve adopted precludes us following standard diversification dogma. Many pundits would therefore say that the strategy must be riskier than that employed by a more conventional investor. However we believe that a strategy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. That is, by purposely focusing on just a few select companies, you are better able to study them closely and understand their intrinsic value. The more knowledge you have about a company, the less risk you are likely to be taking.”
Buffett and his partner Charlie Munger operated their investment partnerships mostly with 5 significant positions. The typical portfolio composition would be to have 80% in 5 positions, with 25% for the largest. Buffett is quoted as saying that “In 1964 I found a position I was willing to go heavier into, up to 40%. There were various times I would have gone up to 75%, even in the past few years. If it's your game and you really know your business, you can load up. Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position.”
Conclusions
While the elegant mathematical logic of the CAPM demonstrates the benefits of diversification clearly, it must be remembered that the model is theoretical and its reliance on statistical measures of risk (i.e. volatility) can be highly misleading.
Indeed, while few would argue against the benefits of some diversification, empirical evidence demonstrates that, in both the short and the medium-term (1-10 years), returns are generated by investors with superior information and / or a superior investment strategy. Under the CAPM theory, the strategies employed by John Paulson (high conviction calls like shorting the US housing market in 2007 and now buying gold stocks) are highly inappropriate due to their significant concentration and volatility. However it seems nonsensical for a manager who consistently generates major outperformance to be regarded as “high risk”.
We would argue that, for a professional (or highly skilled) investor with confidence, it is difficult to see why concentration should not be as appropriate a strategy as it is for Warren Buffett. However for everyone else, (e.g. part time or novice investors), it is advisable to participate in extensive diversification (i.e. buy the index). Just make sure you don't buy at the wrong price or at the wrong time. To quote Warren Buffett one last time, “if you try to be just a little bit smart, spending an hour a week investing, you're liable to be really dumb.”