This article on diversification strategy was written by Jialin Chua. Jialin is a corporate finance and capital markets consultant in Singapore. She strongly believes in the mantra "price is what you pay, value is what you get," and is always on the lookout for cheap stocks. Her focus is on applying a net net and Acquirer’s Multiple strategy in her personal account. Article image (Creative Commons) by James Lee, edited by Broken Leg Investing.
Have you ever wondered if you are putting too many eggs in a basket? Diversifying your portfolio is a risk management strategy that offers some sort of protection from adverse stock market conditions and reduces your loss without sacrificing your returns at the same time.
This sounds challenging indeed, but it is definitely achievable. In order to meet the optimal number of stocks an investor should have in a portfolio, one has to answer several important questions: What is your diversification strategy? How do you align your diversification strategy to deep value investing strategy? Finally, how much do you need to diversify?
Risks Investors Face
Before we decide on the diversification strategy or how much we should diversify, we need to first understand the two main types of risks that investors face — systematic risk and unsystematic risk.
Systematic risk is associated with every company and is not specific to a particular company or industry. This means that systematic risk cannot be eliminated or reduced through diversification strategy, and investors will have to accept this risk. This usually refers to macroeconomic factors. Common sources of systematic risk include inflation rates, exchange rates, political instability, war, and interest rates.
On the other hand, unsystematic risk is exclusive to a company, industry, market, economy, or country, and it includes such items as business risk and financial risk. In short, unsystematic risk can be reduced, and we can control this using a diversification strategy.
Our aim is to invest in a number of deep value stocks so that your portfolio is not affected the same way by market events, minimizing the correlation as much as possible.
Do You Diversify?
Prior to buying a deep value stock with attractive returns, do you pause for a second to think about how much money you should put in, the percentage that particular stock will occupy in your portfolio, or what your remaining portfolio has?
Most people become blinded by excitement when faced with an appealing deep value stock with tempting returns. Without a second thought on the questions above on diversification strategy, they start dumping whatever cash they have on hand or even maximize their leverage, just so they can buy and own the stock immediately. The eagerness to own the stock clouds their judgment. This results in an imbalanced portfolio. Any drop in their portfolio will be too much to stomach — as emotions overwhelm them, this may cause panic selling, compounding their losses.
It does not matter if you have the best deep value investing strategy or the best deep value stocks if we are not able to stick by them even if they are still a fundamentally good business at a bargain price.
For example, if your whole portfolio consists of only poultry processing stocks, and there is a public announcement that farmers are going on an indefinite strike, causing a halt in work, share prices of poultry stocks will drop instantly. Your portfolio will, therefore, experience an evident drop in value as well. If, however, you counterweight the poultry industry stocks with a couple of seafood processing industry stocks, only part of your portfolio would be affected. In fact, since seafood is an alternative form of food, there is a good chance that the seafood stock prices will climb.
However, both poultry and seafood are sectors in the food processing industry, and there are still many risks involved. An event such as a disease outbreak will cause distress in both sectors and cause a drop in your portfolio.
In these two scenarios, both events may or may not affect the value of the business, but there will definitely be a temporary change in prices due to fear. This sounds like bad news to investors, but bad news can be good or bad — and similarly, good news can be good or bad. It all depends on your perspective. Using the examples from above, this news may provide you with opportunities to buy more and have a better entry point. If you own another vegetable agriculture stock, this will increase the prices temporarily since it is a food alternative and you take profits off the table if it has met its intrinsic value.
Thus, if you are unable to withstand such news headwinds, you should further diversify your portfolio by building a pool of uncorrelated stocks across different types of industries, not just the different types of companies. By having a broad portfolio of a hundred stocks, even if one company were to go drop 50 percent, or even worse, goes bankrupt or becomes delisted from the exchange, your portfolio will only be one percent affected. Comparing this to a ten stock portfolio, if there is any misjudgment or unforeseen circumstances, the drop in your portfolio will affect ten percent of your capital. This may be too much for a novice investor to handle.
The Relationship Between Diversification and Risk Tolerance
So, how many stocks should a deep value investor hold? This comes down to your personal risk tolerance for the volatility of stock prices.
Risk tolerance is thought of in two different ways — the amount of risk one is willing to take and the amount of risk one is able to take. The amount of risk a deep value investor is willing to take depends on an individual’s personality and behavior — whether you are able to stomach the fluctuations in your portfolio and how confident you are with a deep value investment strategy. The amount of risk that a person can take varies with a person’s financial situation and investment goals. It is dependent on your current life milestone as well. An investor saving for retirement decades down the road will more likely be comfortable taking on risk than an investor saving for a housing down payment. Another example: a middle age investor with a stable job is likely to be more risk tolerant than a fresh graduate with student loans.
Diversification Strategy: Your Investment Approach
Hence, to select your diversification strategy, there are three approaches that a deep value investor can adopt.
The first diversification strategy is a passive method. For this method, you will buy a basket of the 30 cheapest deep value stocks. This is suitable for deep value investors who have very little time to devote to understanding stocks and want to automate their deep value investment strategy.
On the contrary, an active method is apt for investors who are willing to commit and spend at least 5 to 10 hours a week analyzing companies to have a deep understanding of stocks and financial statements. You will know the business inside and out — from the array of products and the geographical sales to the management team and board of directors. This requires you to handpick and invest in a handful of deep value stocks — about 8 to 10 stocks in all.
The third approach is to combine both passive and active methods and find a middle ground — the balanced method. This is for deep value investors who have a basic understanding of stocks and are willing to do limited research to identify good companies to invest in. It is recommended to hold about 15 to 20 stocks in your portfolio for this approach.
Based on the above approaches, you will notice that the amount of time you spend on reading up on businesses and their stocks has a direct relationship with how many stocks you need to own in your portfolio. This is because the less time you spend on them, the greater the chance that you may be wrong due to ignorance or blind spots that were not identified in the first place.
It is also important to not over-diversify your portfolio. Over-diversifying refers to the point whereby marginal loss of expected return will be greater than the marginal benefit of reduced risk. Holding too many deep value stocks lowers the expected returns and will create a double-edged sword – hurting your portfolio.
Diversification Strategy: Deep Value Investors
Deep value investors typically start the stock selection process by going through a criteria checklist. This includes avoiding certain industries, such as real estate or financial companies, that we have no interest in. Thereafter, we focus on finding the best bargained deep value stock in our circle of competence – what we understand best. It is difficult to cherry-pick and dismiss buying a particular stock solely based on the industry or sector it is in, as it may not be easy to find one after filtering out undesired industries.
We can only try to decide how many stocks we want to hold based on our approach to deep value diversification strategy, whether it is passive, active, or balanced. The purpose of diversification strategy is to reduce the volatility in your portfolio without worrying about the market’s movements. The key is to be comfortable with what you are holding so that even if you lose 50 percent of your portfolio’s value, you will be confident enough to stick with your investments unless the fundamentals of the companies have changed.
As Warren Buffett once famously said, “Diversification is a protection against ignorance. It makes little sense if you know what you are doing.” Hence, diversification can be of great assistance to your portfolio when you have a lack of knowledge and can handicap you at the same time if you have a good understanding of the business. The ideal portfolio diversification strategy is to own a number of deep value stocks large enough to nearly eliminate ignorance but small enough to concentrate on the best opportunities.
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