Concentrated Diversification

Posted in Blog
13/05/2019 Mduduzi Luthuli

Most people would rather save their money in a bank somewhere than invest, mainly because of the risks associated with investing. They dread the thought of risking their hard-earned money because they fail to understand one of the most basic and effective risk management techniques – diversification.

Diversification can be neatly summed up as, “Don’t put all your eggs in one basket.” The idea is that if one investment loses money, the other investments will make up for those losses. Diversification can’t guarantee that your investments won’t suffer if the market drops. But it can improve the chances that you won’t lose money, or that if you do, it won’t be as much as if you weren’t diversified.

The goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses. But once you target a level of risk—based on your goals, time horizon, and tolerance for volatility—diversification may provide the potential to improve returns for that level of risk.

To build a diversified portfolio, you should look for assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much.

Another important aspect of building a well-diversified portfolio is trying to stay diversified within each type of asset. Within your individual stock holdings, beware of over-concentration in a single asset. For example, you may not want one stock to make up more than 5% of your stock portfolio.

We at Luthuli Capital believe it’s smart to diversify across stocks by market capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions have prospered at the same time, or to the same degree, so you may be able to reduce portfolio risk by spreading your assets across different parts of the stock market. You may want to consider a mix of styles too, such as growth and value.

When it comes to your bond investments, consider varying maturities, credit qualities, and duration, which measure sensitivity to interest-rate changes.

Concentration vs. Diversification

There is a debate between investors who believe in concentration and those that believe in diversification. Our belief is there are few stock analysts competent enough to concentrate in less than 10 stocks.

Intense concentration leaves no room for errors in your analysis. It also inflicts a large penalty when something unforeseen causes a severe reduction in price of a single stock or a particular industry. Those who concentrate in one stock are particularly at risk. This is usually done by investors who are employees, or former employees, of a company. They have an emotional bias that causes them to take undue risk.

In extreme cases (i.e. Enron in 2000 or Steinhoff in 2017) employees lose their job, their retirement, and their life savings. This kind of extreme concentration is particularly dangerous. At the other extreme are those who believe in diversification without limits. Owning many actively-managed funds and/or ETFs can result in owning hundreds or even thousands of assets. This much diversification assures a mediocre or average return.

In our opinion, diversification beyond 40 – 50 stocks is needless and counterproductive. You want to own enough investments to mitigate specific risks but still own the best investment ideas. Many financial analysts agree that 15 – 35 individual stocks will provide significant diversification from specific risk. We like to make allowances for additional diversification for special situations, deep value bargains, etc.; but we would rarely ever go beyond 35 individual investments. Very few investors can even keep up with more than 35 different companies.

Final Thoughts

Portfolio diversification is a balance between concentration and over diversification. It allows you to significantly reduce specific risk whilst simultaneously concentrating on the best opportunities. Now, with a better understanding of what portfolio diversification is, you can build your risk management plan and establish your optimal amount of concentration.

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