Diversifying investment portfolio

[jeremykl]

Does anyone practice portfolio diversification? Is this done through ETFs or individual stocks?

If stocks, how many stocks are required and what process do you undertake to ensure there is diversification?

 

[Wysiwyg]

With regards to stocks, my experience of spreading your money across numerous stocks reduces long term returns due to additional brokerage, reduced dividend yield and reduced winner profits. I hold 1 to 6 stocks that I consider have bright futures plus good dividend yield and I watch them closely. Consider quality rather than quantity.

As far as assets diversification, hopefully others will present some experiences.

 

[So_Cynical]

With regards to stocks, my experience of spreading your money across numerous stocks reduces long term returns due to additional brokerage, reduced dividend yield and reduced winner profits.

I hold a lot of stocks across my 3 portfolios (35+) lots of stocks flattens return, due to smaller exposure to outlier winners and losers...that's my experience - real diversification in stocks must also include market/currency diversification.

 

[Wysiwyg]

I hold a lot of stocks across my 3 portfolios (35+) lots of stocks flattens return, due to smaller exposure to outlier winners and losers...that's my experience - real diversification in stocks must also include market/currency diversification.

The see-saw effect? One up one down.

 

[thembi]

Does anyone practice portfolio diversification? Is this done through ETFs or individual stocks?

If stocks, how many stocks are required and what process do you undertake to ensure there is diversification?

I have found that ETFs are a fantastic way to diversify portfolios and reduce the risk of 'single stock exposure'. With an ETF such as say QOZ, you can get exposure in one trade to a diversified portfolio of (in that case) 200 stocks. My approach is to use an ETF as a core holding within my share portfolio and then buy some more speculative satellites single stocks where appropriate.

I also use ETFs to diversify my portfolio beyond stocks to include things like small allocations to commodities (such as Gold) or to tilt to sectors that I am currently feeling more confident on (like financials sector at the moment)

 

[So_Cynical]

The see-saw effect? One up one down.

Yes - but because there are so many stocks the see-saws are small, also more winners than losers over time but the losers do knock the cream off the top.

 

[Triathlete]

Does anyone practice portfolio diversification? Is this done through ETFs or individual stocks?

If stocks, how many stocks are required and what process do you undertake to ensure there is diversification?

In my case my trading portfolio would only contain between 5 and 8 stocks

Medium / long term portfolio would have between 8 and 12 stocks.

It is all about how you are going to manage your risk factor:

For example if you only have one stock then the specific risk is high.

Then as you increase your holdings the specific risk decreases and flat lines somewhere between 5 and 12 shares .

Increasing your the holdings above 12 stocks then exposes the portfolio to market risk which cannot be eliminated by diversification.

If I was just starting out I would be concentrating on big companies say in Top 50 ASX That are fundamentally sound that are rising in price no matter what sector they come from.

Having an understanding of Technical analysis would also help your decision making in my opinion also.

 

[Wysiwyg]

For example if you only have one stock then the specific risk is high.

No it isn't because you position size correctly. For example no more than 20% of total equity in one stock and 1% of total equity at risk. Gap downs aside.

 

[Triathlete]

No it isn't because you position size correctly. For example no more than 20% of total equity in one stock and 1% of total equity at risk. Gap downs aside.

I see your point....

But now we are talking about how the allocation of capital towards your stock picking is distributed in your portfolio.

A different topic all together.

 

[jeremykl]

thanks everyone for your feedback so far.

From my research, I found this study which shows that you need 38 Aussie stocks to achieve a diversified portfolio ...

http://www.utas.edu.au/__data/asset...nd-Tapon-Equity-portfolio-diversification.pdf

On that basis, the cost of achieving true diversification using individual stocks (vs ETFs) becomes very high due to transaction costs. Say $10 per trade (Bells Direct), you are paying $380 just in brokerage.

On the other side, the management fee of the ETFs (usually around 0.2%, but compounding) needs to be balanced out.

It seems like the size of the investment portfolio will determine which is the more cost effective method.

Additionally, we prob need to consider time to manage the portfolio and rebalancing / reinvestment risks as well

 

[galumay]

thanks everyone for your feedback so far.

From my research, I found this study which shows that you need 38 Aussie stocks to achieve a diversified portfolio ...

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Thats just one opinion, you certainly dont NEED 38 companies to have a diversified portfolio. Its a very subjective concept, many different answers will come depending on peoples strategies, investing philosophies and risk management style.

Personally i dont like more than about a dozen companies, it becomes to hard to fully understand the buinesses and follow them intimately if my portfolio gets bigger than that. There is a real danger in diversifying for the sake of it that you add companies that are either too expensive or not good enough quality to your portfolio.

All of the above is from a fundamental, value investment point of view, no doubt other styles of investors and traders would have a different viewpoint.

 

[Value Collector]

In my opinion it comes down to skill level and the time you put into understanding and following the companies you hold.

If you are a highly knowledgeable investor, that's put in a lot of effort to know your positions, 6 companies would probably be enough diversification.

If you're an unskilled passive investor, you need large diversification, probably an asx200 index is best for you.

 

[Value Collector]

In my opinion it comes down to skill level and the time you put into understanding and following the companies you hold.

If you are a highly knowledgeable investor, that's put in a lot of effort to know your positions, 6 companies would probably be enough diversification.

If you're an unskilled passive investor, you need large diversification, probably an asx200 index is best for you.

I just realised I swiped this concept from buffet, I have read and watched so much Buffet stuff, sometimes it's hard to remember whats come from him and what are my own original ideas.

 

[luutzu]

I just realised I swiped this concept from buffet, I have read and watched so much Buffet stuff, sometimes it's hard to remember whats come from him and what are my own original ideas.

haha... best to just accept that you got no original ideas when it comes to investing. I did.

I got a few brilliant moments, pad on the back, well done you genius... then I kept reading Graham and Dodd and damn it. But it's good how investing doesn't pay you to be original, just being able to apply sound business principles.

 

[Value Collector]

But it's good how investing doesn't pay you to be original, just being able to apply sound business principles.

Very true.

 

[thembi]

Bottom line on diversification is this.. if you do actually want a diversified portfolio, at a low cost, there is no easier or cheaper way to get it than via an ETF.

As to whether or not you actually want or need diversification however, that is a whole different subject and is up to each individual investor.

 

[galumay]

Bottom line on diversification is this.. if you do actually want a diversified portfolio, at a low cost, there is no easier or cheaper way to get it than via an ETF.

As to whether or not you actually want or need diversification however, that is a whole different subject and is up to each individual investor.

You may gain portfolio diversification through an ETF but sacrifice other outcomes. Thats why a balanced approach is required, taking all options into consideration and understanding what the impacts are in all directions.

I think Buffet's point is well made, if you are happy not trying to beat the index, then ETF's give you both relative performance to an index and internal diversification within the asset class.

If you want to try to beat the indexs and/or have absolute performance benchmarks then diversification is just about the worst thing you can do, but as he says ony a tiny proportion of investors have the discipline and the long term view to be able to achieve such a strategy.

 

[jeremykl]

Thats just one opinion, you certainly dont NEED 38 companies to have a diversified portfolio. Its a very subjective concept, many different answers will come depending on peoples strategies, investing philosophies and risk management style.

Personally i dont like more than about a dozen companies, it becomes to hard to fully understand the buinesses and follow them intimately if my portfolio gets bigger than that. There is a real danger in diversifying for the sake of it that you add companies that are either too expensive or not good enough quality to your portfolio.

All of the above is from a fundamental, value investment point of view, no doubt other styles of investors and traders would have a different viewpoint.

Agree that 38 companies are required to achieve diversification is one opinion - but it sounds about right based on the maths / analysis shown in the research. It is difficult to see how 12 stocks can achieve diversification based on that research.

I agree that if you own stocks, you should understand them, select them based on quality, valuation, etc. This is very hard to do if you own 38 stocks.

I'm landing at an understanding that:
+ diversification = exposing yourself you market risk only
+ an investment strategy that is about diversification is aiming to achieve market returns
+ doing so will sacrifice some alpha (outperformance against the market)
+ if you want a diversified portfolio you should stick to ETFs, stock picking isn't going to work
+ mainly bc you need 38 stocks to achieve diversification, and most people won't have the time (and probably skills) to pick the 38 stocks required
+ you may need more or less than 38 stocks to achieve diversification for the purposes discussed here, but it's likely to be pretty close in terms of number

Actually just thought of something else ... we haven't factored in the cost of implementing the alternative solutions to diversification

a) 38 stocks buy and hold will incur significantly brokerage vs
b) buying into an ETF will have lower brokerage but incur an on-going mgmt fee from ETF manager (compounding)

Maybe this is a major factor in deciding whether ETFs or portfolio of stocks is best in implementing a diversified strategy

 

[DeepState]

I'm landing at an understanding that:
+ diversification = exposing yourself you market risk only
+ an investment strategy that is about diversification is aiming to achieve market returns
+ doing so will sacrifice some alpha (outperformance against the market)
+ if you want a diversified portfolio you should stick to ETFs, stock picking isn't going to work
+ mainly bc you need 38 stocks to achieve diversification, and most people won't have the time (and probably skills) to pick the 38 stocks required
+ you may need more or less than 38 stocks to achieve diversification for the purposes discussed here, but it's likely to be pretty close in terms of number

Actually just thought of something else ... we haven't factored in the cost of implementing the alternative solutions to diversification

a) 38 stocks buy and hold will incur significantly brokerage vs
b) buying into an ETF will have lower brokerage but incur an on-going mgmt fee from ETF manager (compounding)

Maybe this is a major factor in deciding whether ETFs or portfolio of stocks is best in implementing a diversified strategy

Just some alternative viewpoints (this stuff is what happens in tightly risk managed hedge fund portfolios):

Diversification is one way to rid yourself of unwanted and/or unrewarded risk. In many exchanges on ASF, diversification is taken to mean surrender in the face of uncertainty and the acceptance of mediocrity as the less worse outcome. That would be a fairly serious misjudgment if regarded as a universal statement.

There can be all sorts of different kinds of risk. Many of these can be managed via the tool of diversification. There are many other ways (eg. derivatives, stops..). The most common alternative to diversification as a means to limit your exposure to unwanted risk is usually not to take any exposure in the first place. The final alternative is just to take it and justify it with a wave to the long term...as if risk managing for the near term is somehow not consistent with getting to the long term with higher probability.

You can build diversified portfolios of stocks that are no where like the market portfolio.

By limiting your exposure to unwanted risks by diversification, you increase your exposure to skill or, otherwise, the part of risk that you want. For example, if your view is only that iron ore is going up, you would buy an appropriately diversified portfolio of iron ore stocks - or just the iron ore futures. You have no view on the outlook for individual companies or the value the market is ascribing to it. In that situation, it doesn't make sense to concentrate your positions in any single stock as you have no particular view on that one stock but you are totally exposed to the events specific to that stock as well as everything else. All those risks, apart from the anticipated movement in the price associated with iron ore price movements, are completely unrewarded ex ante, in this case. You have no view, but are taking the risk.

Diversifying does not have to eliminate alpha. Quite the opposite occurs in sophisticated risk management. By diversifying appropriately, you can actually take pure alpha bets where that alpha is something which spans several companies (eg. like outlook for interest rates or some legislative development). Building appropriately diversified portfolios will give you a much purer exposure to such concepts. At the extreme, you will build diversified long/short portfolios to hone in on that alpha. Also, if your insight happen to be something specific to a company like a new type of super-market format, it may not the best thing you can do just to buy that stock. It is exposed to lots of other things that have nothing to do with that idea in pure form (per the iron ore example, except there are no futures on the supermarket format available). The best way to get this idea is to buy the company and sell a diversified portfolio of other companies that otherwise mimic the target as best as possible, except for the bit you want. That way, the risk you have left is as close as possible to the idea you actually have some notion on.

Investment is about finding underpriced cash flows. These cashflows arise from operations of lots of different types. If your view is targeted, diversification can help you get much closer to that idea than a simple holding in that company.

This is what diversification means to me and people who do this type of stuff. It is hardly synonymous to throwing up your hands in a cheer for mediocrity. For us, knowing what you actually have as an edge and not doing this to concentrate your risk purposefully into that edge is an exemplar of mediocre practice. It is about accurately implementing what it is you have a notion on. For at least some of us lesser mortals, that notion or edge doesn't come in neat packets of single stock like Buffett is presumed to be saying.

Buffett understands risk. He is very clear on the kind of investment situation that BRK is suitable for. Many/most of the people on ASF would not actually qualify for his original idea of suitable shareholders (which is why the stock never split for ages and became to large a parcel for many less wealthy people). He goes on and on about Ajit in every report, for example. Ajit manages risk by diversification and further reinsurance. He is absolutely in the risk business and he cares about it on a on a risk by risk basis (and also gross exposure basis). That's also investment (Selling expected low cashflow relative to premium received) and it is the biggest swing factor in BRK. Buffett's beef is with over-diversification. I have no problem with that. The problem arises when that statement is misconstrued in every context that the word 'diversification' arises in.

 

[galumay]

I have no problem with that. The problem arises when that statement is misconstrued in every context that the word 'diversification' arises in.

Its pretty clear what his view is on portfolio diversification, he states it in simple terms in the linked videos and in other interviews, writings, transcripts etc.

I think your views on diversification and risk management are interesting, its always informing to read of alternative approaches and differing opinions and your posts always have a very detailed explanation of your opinions and thinking which helps me improve my understanding of the various approaches to these fields.