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Diversification: Too Much of a Good Thing, Can Be a Great Thing
Posted by: TannorP (IP Logged)
Date: August 14, 2013 10:43AM

Berkshire Annual Shareholder Letter:

“That’s assured by the general volatility of the stock market, by the concentration of our equity holdings in just a few companies, and by certain business decisions we have made, most especially our move to commit large resources to super-catastrophe insurance."

We not only accept this volatility but welcome it: "A tolerance for short-term swings improves our long-term prospects. In baseball lingo, our performance yardstick is slugging percentage, not batting average.”

Warren Buffett once said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

Humans love diversification and this can be attributed to the diversification bias, as we do not like to lose an option even if the option was a bad one. Sometimes less is more and quality is better than quantity. Risk is not adequately reduced by further diversifying your stock market holdings as they are all susceptible to the same systematic risks (depending on credit class). Diversification would not have been able to entirely save you from October 2007 to March 2009 (during the credit crisis) the S&P500 declined 57%. While many companies did close their doors for good, many survived and have thrived in the new environment.

Extreme bargains do not come around everyday and it is best to go for the jugular when the opportunities present themselves, focusing your holdings in the cream of the crop.

Of course, if you insist on diversifying and are happy with average market returns, continue the 30-to-50 basket holding approach. But why not buy a low cost index fund and save yourself the headache of choosing winners and discarding losers? The systematic risk of a portfolio cannot be diversified away no matter how many holdings you decide to have. Although diversification can reduce the risk of individual securities from business failure or traumatic events and does help reduce risk initially, the average portfolio returns began to diminish after five holdings as depicted in “The Effect of Diversification on Risk” in the Financial Analyst Journal Vol. 27, No.6 (Nov-Dec) 1971 by W. H. Wagner and S. C. Lau.

As shown above, the standard deviation is not affected greatly after five to 10 holdings and after 50 holdings, there is virtually no effect.

Ben Graham was an advocate of diversification using qualitative analysis as a guide to buy under valued securities selling under book value or “net-nets.” Over time, most holdings would recover, although a few would perish, but on average a reasonable return would be made for the owner of the basket of value. Buffett has been quoted saying, “The irony is that while Graham was a qualitative investor, he made more money investing in Geico than all other investments his firm made, combined.”

Guru Discussed: Warren Buffett: Current Portfolio, Stock Picks
Stocks Discussed: SPY, BRK.A, BRK.B,
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