Every investor wants to (or should certainly want to) achieve the highest rate of return with the lowest risk possible. But how does one actually go about reducing portfolio risk? In his book, "Margin of Safety," value investor Seth Klarman (Trades, Portfolio) takes a deep dive into this topic by looking at diversification as a method for reducing risk.
Don’t put all of your eggs in one basket
Most people, even if they are not actively investing in the market, intuitively understand the value of diversification. For instance, they probably feel that having multiple streams of income gives them a stronger sense of security than relying on just one. “Don’t put all of your eggs in one basket” is a popular idiom because it is easily understood by the general public.
However, when it comes to the specifics of capital deployment, some of us have trouble with the concept of diversification. For instance, if an investor has half of their money invested in U.S. airline stocks and the other half in railroads, are they really diversified? If air travel becomes less popular (either because travelers become more environmentally conscious or due to an exogenous event like 9/11), the investor will be appropriately protected due to the increase in train traffic. So in one way, this is a somewhat diversified portfolio.
But in a larger sense, it is not. For one thing, if all types of travel decline, then both parts of the portfolio will suffer. For another, all the companies are U.S.-based. What if something happens to the U.S. economy? Finally, all the assets in the portfolio are stocks. What if something happens to the stock market worldwide?
As you can see, there are varying degrees of diversification, and an astute investor needs to consider all of them. Of course, you shouldn’t be overdiversified. Here’s Klarman’s take on it:
“The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen holding usually suffice. Advocates of extreme diversification - which I think of as overdiversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings.”
In other words, what matters is how well you know your portfolio, rather than how many positions you hold. A portfolio with 500 companies might actually be less well diversified than a portfolio containing a mix of stocks, bonds, cash and perhaps even other asset classes like commodities or real estate. It’s more important to be smart about your holdings than trying to make it up by sheer weight of numbers.
Read more here:
- Howard Marks: Why We Need Recessions and Bankruptcies
- Warren Buffett: How to Read Annual Reports
- Howard Marks: We Are In Uncharted Territory
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