Best of the Week
Most Popular
1.The Gallery of Crowd Behavior: Goodbye Stock Market All Time Highs - Doug_Wakefieldth
2.Tesco Meltdown Debt Default Risk Could Trigger a Financial Crisis in Early 2015 - Nadeem_Walayat
3.The Trend Every Nation on Earth Is Pouring Money Into - Keith Fitz-Gerald
4.Do Tumbling Buybacks Signal Another Stock Market Crash? - 26Mike_Whitney
5.Could Tesco Go Bust? How to Save Tesco from Debt Bankruptcy Risk - Nadeem_Walayat
6.Gold And Silver Price - Respect The Trend But Prepare For A Reversal - Michael_Noonan
7.U.S. Economy Faltering Momentum, Debt and Asset Bubbles - Lacy Hunt
8.Bullish Silver Stealth Buying - Zeal_LLC
9.Euro, USD, Gold and Stocks According to Chartology - Rambus_Chartology
10.Evidence of Another Even More Sweeping U.S. Housing Market Bust Already Starting to Appear - EWI
Last 5 days
Stocks Bear Market Crash Towards New All Time Highs as QE3 End Awaits QE4 Start - 31st Oct 14
US Mortgages, Risky Bisiness "Easy Money" - 30th Oct 14
Gold, Silver and Currency Wars - 30th Oct 14
How to Recognize a Stock Market “Bear Raid” on Wall Street - 30th Oct 14
U.S. Midterm Elections: Would a Republican Win Be Bullish for the Stock Market? - 30th Oct 14
Stock Market S&P Index MAP Wave Analysis Forecast - 30th Oct 14
Gold Price Declines Once Again As Expected - 30th Oct 14
Depression and the Economy of a Country - 30th Oct 14
Fed Ends QE? Greenspan Says Gold “Measurably” “Higher” In 5 Years - 30th Oct 14
Apocalypse Now Or Nirvana Next Week? - 30th Oct 14
Understanding Gold's Massive Impact on Fed Maneuvering - 30th Oct 14
Europe: Building a Banking Union - 30th Oct 14
The Colder War: How the Global Energy Trade Slipped From America's Grasp - 30th Oct 14
Don't Get Ruined by These 10 Popular Investment Myths (Part VIII) - 29th Oct 14
Flock of Black Swans Points to Imminent Stock Market Crash - 29th Oct 14
Bank of America's Mortgage Headaches - 29th Oct 14
Risk Management - Why I Run “Ultimate Trailing Stops” on All My Investments - 29th Oct 14
As the Eurozone Economy Stalls, China Cuts the Red Tape - 29th Oct 14
Stock Market Bubble Goes Pop - 29th Oct 14
Gold's Obituary - 29th Oct 14
A Medical Breakthrough Creating Stock Profits - 29th Oct 14
Greenspan: Gold Price Will Rise - 29th Oct 14
The Most Important Stock Market Chart on the Planet - 29th Oct 14
Mysterious Death od CEO Who Went Against the Petrodollar - 29th Oct 14
Hillary Clinton Could Be One of the Best U.S. Presidents Ever - 29th Oct 14
The Worst Advice Wall Street Ever Gave - 29th Oct 14
Bitcoin Price Narrow Range, Might Not Be for Long - 29th Oct 14
UKIP South Yorkshire PCC Election Win is Just Not Going to Happen - 29th Oct 14
Evidence of New U.S. Housing Market Real Estate Bust Starting to Appear - 28th Oct 14
Principle, Rigor and Execution Matter in U.S. Foreign Policy - 28th Oct 14
This Little Piggy Bent The Market - 28th Oct 14
Global Housing Markets - Don’t Buy A Home, You’ll Get Burned! - 28th Oct 14
U.S. Economic Snapshot - Strong Dollar Eating into corporate Profits - 28th Oct 14
Oliver Gross Says Peak Gold Is Here to Stay - 28th Oct 14
The Hedge Fund Rich List Infographic - 28th Oct 14
Does Gold Price Always Respond to Real Interest Rates? - 28th Oct 14
When Will Central Bank Morons Ever Learn? asks Albert Edwards at Societe General - 28th Oct 14
Functional Economics - Getting Your House in Order - 28th Oct 14
Humanity Accelerating to What Exactly? - 27th Oct 14
A Scary Story for Emerging Markets - 27th Oct 14
Could Tesco Go Bust? How to Save Tesco from Debt Bankruptcy Risk - 27th Oct 14
Europe Redefines Bank Stress Tests - 27th Oct 14
Stock Market Intermediate Correction Underway - 27th Oct 14
Why Do Banks Want Our Deposits? Hint: It’s Not to Make Loans - 26th Oct 14
Obamacare Is Not a Revolution, It Is Mere Evolution - 26th Oct 14
Do Tumbling Buybacks Signal Another Stock Market Crash? - 26th Oct 14
Has the FTSE Stock Market Index Put in a Major Top? - 26th Oct 14
Christmas In October – Desperate Measures - 26th Oct 14
Stock Market Primary IV Continues - 26th Oct 14
Gold And Silver Price - Respect The Trend But Prepare For A Reversal - 25th Oct 14
Ebola Has Nothing To Do With The Stock Market - 25th Oct 14
The Gallery of Crowd Behavior: Goodbye Stock Market All Time Highs - 25th Oct 14
Japanese Style Deflation Coming? Where? Fed Falling Behind the Curve? Which Way? - 25th Oct 14
Gold Price Rebounds but Gold Miners Struggle - 25th Oct 14
Stock Market Buy the Dip or Sell the Rally - 25th Oct 14
Get Ready for “Stupid Cheap” Stock Prices - 25th Oct 14
The Trend Every Nation on Earth Is Pouring Money Into - 25th Oct 14 - Keith Fitz-Gerald
Bitcoin Price Decline Stopped, Possibly Temporarily - 25th Oct 14

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

Stocks Epic Bear Market

Investing Diversification: Is It All It's Cracked Up To Be?

InvestorEducation / Learning to Invest Apr 20, 2012 - 12:49 AM GMT

By: Charles_Carnevale

InvestorEducation

Investing Diversification: Is It All It's Cracked Up To Be?Diamond Rated - Best Financial Markets Analysis ArticleThere's an old cliché about real estate investing that states that the three cardinal rules are: location- location- location. Clever pundits have borrowed upon this refrain and glibly state that the three most important or cardinal rules of investing are: diversify- diversify- diversify. However, careful analysis will reveal that diversification is a multifaceted concept that has different meanings, benefits and even risks depending on how it's used and what its ultimate purpose is. Therefore, my goal is to examine this ubiquitous investing concept from various angles and perspectives.


Diversification Within or Across

When thinking about diversification there are at least two broad categories to contemplate. The first I would call broad diversification or spreading the risk across numerous asset classes. To me, this is analogous to the throw as much mud on the wall as you can while hoping that some will stick idea. Many experts advocate the diversifying broadly approach. However, to my way of thinking, the idea of diversifying just for diversification sake is not always a sound idea. In other words, I would never advocate putting money into an investment that prudent analysis indicated was a bad place to invest just for the sake of so-called diversification.

For example, and I know it is going to generate strong disagreement, I think gold is an asset class at a bubble valuation that should be currently avoided. Personally, I sold mine last summer. The following graph courtesy of Goldprice.org says it all. Gold was an attractive investment in the late 1990's to early 2000's, but it is clearly at extremely high levels now. Therefore, I would suggest taking some (or even all) profits. As I have written before, I feel that fixed income (bonds, etc.) is also at an extreme, and therefore, I temporarily also favor avoiding this asset class. I feel that asset classes should only be used for diversification when they are prudent and sound. To force money into a dangerous investment solely for an artificial commitment to diversification makes no sense to me.

Gold a Twenty year History (Courtesy of Goldprice.org)

Gold a Twenty year History

Furthermore, I tend to have a much narrower view of asset classes than many of my peers. Regarding liquid assets I see only what I call owner-ship or loaner-ship. Where owner-ship represents equity with the investor positioning themselves as an owner/shareholder, and loaner-ship where the investor loans their money at interest. Others might call this equity versus fixed income or stocks versus bonds. In addition to these liquid assets there would also be hard assets such as real estate, precious metals, commodities and art forms that could be considered as options. But the most important point is that deciding what the most appropriate or optimum percentage of your assets should be allocated to these various asset classes is a subject of much debate.

Diversification-what is the goal?

The most common definition, and therefore use, of diversification is as a risk management technique. This most basic concept of diversification says that you should not put all of your eggs in one basket. On the other hand, assuming that this is wise counsel raises the question: how many baskets is the appropriate number? Should you spread your money over 5 baskets, 10 baskets, 20 baskets, 100 baskets or 1000 baskets? In other words, what is the optimum number of baskets; how many baskets are enough and/or how many are too many?

When dealing with broad diversification, I refer you back to my previous comments regarding equity versus debt. There are many who advocate cute little rules that they promote as the proper way to apply broad diversification. For example, one of the more popular rules of thumb goes something like this: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. If you are 60 years old, put 40% of your assets in stocks and 60% in bonds, etc. Somehow, these little rules of thumb leave me cold. To my way of thinking, a proper asset allocation plan should be based on the individual's goals, objectives and risk tolerances. When dealing with these kinds of issues, one size rarely fits all.

Next there's the issue of whether your diversification objectives are geared towards reducing risk or maximizing return. An investor with a high tolerance for risk would take a different view of what optimum diversification is versus a person who is very risk averse. An individual with a high tolerance for risk might choose only to invest in equities in lieu of owning any fixed income assets. Who can say that this is a bad decision when it suits the investors' goals and risk tolerances? This then takes us to the questions pertaining to optimum diversification within an asset class.

The most interesting aspect of these important questions is the fact that there is no consensus view. Some experts argue in favor of more diversification while others favor less. For example, Charlie Munger, the famed partner of Warren Buffett, believes that 3 to 5 companies in a stock portfolio is enough diversification. Charlie is alleged to have said that diversification is for idiots. And he is quoted as saying: "wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results. " Alternatively, Warren Buffett seems to agree and has said: "diversification is protection against ignorance."

In contrast, Peter Lynch, the famed manager of the Fidelity Magellan Fund during its glory years held more than 1000 stocks in his portfolio. What is most amazing about this fact is that Peter created one of the strongest long-term track records of any mutual fund that ever existed. Ironically, this is the same man who is credited with coining the phrase "di-worse-i-fication." What many people fail to realize about this is that Peter was referring to an individual company diversifying outside of its core competency through acquisitions. Yet when building his own portfolio, he was happy to own hundreds or even thousands of individual companies.

Then of course there is another aspect of diversifying within an asset class. As it pertains to equities, investors could have a choice of various classes of common stocks. These would include growth stocks versus dividend paying stocks, small stocks versus large stocks, etc. Once again, the investor is faced with the issue of how much should be in growth, how much should be in value, how much should be in large, how much of the small, and on and on. I don't believe there is a general answer. The right answer is the answer that best fits the individual's needs and goals.

And the same concept would apply to investing in bonds. A prudent bond investor might want to ladder their portfolio over various maturities. How much they would allocate to longer maturities versus how much they would allocate to shorter maturities would depend on their belief as to where interest rates might be headed in conjunction with where they feel they are today. If the investor feels that rates are very low they would want to rely more on shorter maturities so that their money would mature into higher interest rates, if they believe rates were going higher. Conversely, if they feel that interest rates are very high they would want to orient their portfolio to the longest maturities possible in order to lock in the higher rates for as long as they possibly could. These considerations would have a major impact on their overall diversification strategy.

There is another argument that the Buffets and Mungers of the world offer against broad diversification. These investors who favor a more concentrated approach believe in essentially two things. First, they believe that extraordinary above-average investments are rare. They further argue that every investment you add would be, or should be, of lesser opportunity than your best choice is. In other words, your best stock will generate a higher return than your second best and so on. Their second belief is that you can only truly know enough about a very select number of companies to be able to invest wisely. Therefore, the more companies you include in your portfolio, the more diluted your knowledge about each will be. In other words they believe in placing all their eggs in one basket (or at least a very few baskets) and then watch that basket very carefully.

Diversification For Maximum Return Or Minimum Risk

As I've previously alluded, diversification is most commonly thought of as a way to reduce risk. However, the opposite side of the diversification coin is rate of return. Diversification, or the lack thereof, will have or should have a large and direct impact on the ultimate return that a portfolio will generate. However, the precise impact is once again a matter of debate. For example, in theory, the more fixed income a portfolio contains the lower the rate of return it would be expected to generate. In his best-selling book Beating the Street, Peter Lynch offered up this 26th Rule of his 25 Golden Rules of Investing (yes, it was his 26th of 25):

"in the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money market account. In the long run, a portfolio of poorly chosen stocks won't outperform the money left under the mattress."

Or you might prefer Peter's principle number two:

"gentlemen who prefer bonds don't know what they are missing."

Perhaps the moral of this story is that diversification has its pluses, but also has its minuses. While it can protect against risk and even smooth out long-term returns; it accomplishes all this at a cost. The seminal question is whether or not you, the individual investor, is willing or even capable of paying the price? Or put another way, how much rate of return are you willing to give up, to buy how much peace of mind? Again, I see this as an individual decision, and perhaps even more importantly, a function of the amount of knowledge you the individual investor possesses and the amount of volatility risk you can endure. Clearly, most of us are not Charlie Munger or Warren Buffett that can afford the luxury of a highly concentrated portfolio. On the other hand, we don't want to be guilty of "di-worse-ification" either. At the end of the day, finding the right balance is as much a personal thing as it is an ironclad principle. At least it is in my way of thinking.

A Fun Look at Diversification Within the Asset Class Equity (stocks)

As I went through the process of researching diversification I came across some interesting results that frankly astounded me. Therefore, I thought it would be fun to share what I discovered. First of all, the primary goal of my research was an attempt to ascertain how much diversification within an asset class was the appropriate amount. Stated more simply, how many stocks were enough to protect the money and how many stocks were too much to dilute or destroy returns. Although I didn't come up with a precise answer that satisfied me, I did discover some fascinating numbers.

Utilizing the F.A.S.T. Graphs research tool I ran 20-year track records on several well-known indices that contained a low of 30 stocks all the way up to 5000 stocks. Before I ran these various records, I assumed that the indicie with the least number of companies would produce the highest rates of return and vice versa.

30 Dow Jones Industrials' 20-year Record

My first example is the DJIA, because it is a diversified portfolio but only contains 30 names. As expected, the 30 Dow Jones Industrials did produce the highest rate of return at 7.3% per annum.

Dow Jones Industrials - 30 STK

The S&P 500 Without Dividends

My second example is the S&P 500. Since the index contains 500 companies, I expected to see a lower annual rate of return due to the much broader diversification. Even though I was correct, the return differential was only 1.2% per annum coming in at 6.1%. From the standpoint of risk, you could say that you didn't give up much return for the greater safety.

Since this article is all about diversification, I have included the sector breakdown of the S&P 500 in order to illustrate the diversification within this broad index. I found it interesting that Information Technology was the biggest sector at 20.46%. To me this indicates that the S&P 500 is actually an aggressive index, even though it is diversified.

Sector Breakdown

Russell 3000 Index Without Dividends

With my third example I increased the size of the universe by a factor of 5 by calculating the Russell 3000. Astonishingly, this larger universe actually generated a modestly higher rate of return of 6.3% per annum versus 6.1% for the S&P 500. In this case, greater diversification actually increased my return, but not by very much.

Russell 3000 Index

The Dow Jones Wilshire 5000

With my final example I calculated the Dow Jones Wilshire 5000 composite which at 5000 names was the biggest index I could find. Remarkably, this biggest index of all produced the highest rate of return at 6.4% per annum.

Dow Jones WILSHIR 5000 CMPST

Frankly, I'm not really certain what to make of the results I discovered. From what I learned, diversification doesn't really impact the rate of return by very much when looked at from the perspective of the average company in the universe. This led me to wondering what a universe of the top 10 best performing stocks might look like. Of course I recognize that the flaw in this line of thinking would be having the foresight to pick the top 10 at the beginning of this exercise. However, my curiosity was not about being smart enough to pick the very best; instead, I was just curious to know what the differentials would actually be.

Therefore, I first sorted the top 10 of the 30 Dow Jones Industrials and listed them in order of best-performing to lowest-performing for the past 20 years. The average performance of an equally weighted investment in each of these candidates would have averaged approximately 13.8% per annum which is just shy of doubling the rate of return for the entire composite of 30 names. To put this into perspective, $1 million equally allocated total investment spread into these top 10 companies would grow to over $12 million in 20 years. I thought this was interesting, but not terribly exciting. The following table shows the results of the top 10 best-performing 30 Dow Jones Industrials with $100,000 invested in each at the beginning of 1993.

With my second example I went to the larger universe of the S&P 500. With a much bigger universe to draw upon a discovered a significantly higher average rate of return. As it relates to diversification, I'm really not sure what this means other than a bigger universe offered a much bigger opportunity to find significantly above-average investments. The top 10 best-performing S&P 500 companies produced an average return of almost 25% per annum. Therefore, the same $1 million equally allocated across these 10 names grew to over $68 million. Now, that number got my attention.

Order by Price

Now, once again, admitting that this last little exercise is fraught with error, I do feel that it revealed some interesting information. Perhaps most importantly, it did reveal a large disparity between the best performers versus the average performance. If you did possess the skills of a legendary investor, you just might be better served to focus your attention on only a few of the very best companies you could identify. However, for the rest of us we might be best served by placing our money spread out and into more baskets.

Summary and Conclusions

As I began digging into the many faces of diversification, I quickly learned that it is a much more complex concept than at first meets the eye. But perhaps most importantly of all, I feel I learned that there is no one-size-fits-all or even a set of universally applicable rules or principles. To a great extent, diversification turns out to be a very personal issue. How much or how little depends more on your goals and objectives, the knowledge and experience you possess, the time you can allocate to your investment portfolio, and of course, your tolerance for risk. Some of us need a great deal of diversification, while others could do with a lot less.

I will conclude this article by confidently stating that it only scratches the surface of what a comprehensive treatise on diversification would require. In many ways, I feel that I raised more questions than I answered. Therefore, I expect that more articles will be forthcoming. The one area that I feel I shortchanged the most was the area of broad diversification across many different asset classes. Consequently, an article dealing specifically with this aspect of diversification seems like a logical next step. However, I will end by saying once again that I believe that it is also a very personal concept. On the other hand, I do believe that no asset class should ever be used unless it makes prudent economic sense to include it.

Disclosure: Long MCHP, MSFT, CVX, ESRX, XOM, UTX, CSCO & INTC at the time of writing.

By Chuck Carnevale

http://www.fastgraphs.com/

Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm.  He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

© 2012 Copyright Charles (Chuck) C. Carnevale - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2014 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Free Report - Financial Markets 2014