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Joe Citarrella
Joe Citarrella
Articles 

Diversification and the Circle of Competence

May 03, 2007

I’ve had some lively debates in the past several days on the issue of diversification. The conventional wisdom is that a portfolio should be diversified to limit the risk of any one position blowing up and destroying returns. Diversification is supposed to “smooth” returns and protect one’s downside. But there’s a catch — the more diversified a portfolio, the more it tends to match the market’s return.

Those espousing conventional wisdom would surely balk after taking a look at my portfolio. I own only three stocks, one of which comprises around 50% of the total assets. Plenty of advisers, academics, etc. would probably think I’m nuts, but I’d like to make a case for a different paradigm of risk and reward. I believe that the determining factor in how much one should diversify turns on how much one understands about the stocks in which they are invested. Graphically, this might look something like:


The reason for this is simple. If one understands and properly evaluates the risks of one’s “best” holdings, they incur opportunity costs by allocating capital to more and more investments. This drags down returns and dilutes the investors’ capacity for understanding any particular investment.

Yes, a focused portfolio will increase the standard deviation of returns, but for long-term investors, this should be of no concern. Risk comes in doing something one does not understand more than from fluctuations in price.

None of this is to say that it’s always a bad idea to diversify. Quite to the contrary, for investors who either do not have the time or skillset to evaluate an individual stock, diversifying is probably a good idea. In fact, I’d recommend index funds (extreme diversification) for the average investor who has neither time nor desire to research investments.

But for those who do wish to pick stocks, as it were, the most important thing they can do is to clearly define a circle of competence — that is, to determine what they understand fully and to stay within that circle. And it’s important to note that it’s not so much the size that matters but how well one defines the outer limits. You don’t have to know many things well or do many things right to beat the market.

About the author:

Joe Citarrella
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.5/5 (4 votes)

Comments

vooch
Vooch - 10 years ago    Report SPAM
I think I once calculated the optimal number of stocks to hold - it was between 6 and 7, and none exceeding 40% weighting.

Unforunately, I'm holding HD right now with a 51% weighting - I owned more than that before I calculated the optimal weighting, but I've been trimming it slowly. I would like to reduce it further, but I'm waiting for the right opportunity to trim it down.

- Vooch


buffetteer17
Buffetteer17 premium member - 10 years ago
Pretty much my thinking. I own 7 stocks right now, with one over the 40% weight (Garmin 45%). When going overweight, I like to use the Kelly Criterion to help me decide how far to go. There's a neat little calculator at http://www.cisiova.com/betsizing.asp.

One problem I have is a conflict between proper diversification and my circle of competence. I don't know how to evaluate real estate, banks, or insurance companies. So there aren't any of these in my portfolio. I'll probably take care of one of these by buying a few shares of BRK-B. Meantime I'm studying up on homebuilders and banks in my copious spare time. Meritage Homes looks interesting due to their solid balance sheet and lack of overexposure to undeveloped land. Bank of America seems to have the right leverage and other ratios for banks. But I need to get beyond the superficial before committing coin.
vooch
Vooch - 10 years ago    Report SPAM
One interesting thing is Buffett won't put more than 40% into a sector either:

http://www.gurufocus.com/holdings_ind.php?GuruName=Warren+Buffett

Here, he's stuffed 40% of his money into Financials and Consumer Goods.

- Vooch

kfh227
Kfh227 - 10 years ago    Report SPAM
Vooch,

If it's any comfort, I own HD. Just bought in last year. Oh, I think HD is at a good price right now.

I also have naked puts against Lowes.

I think both stocks are going to do very well going forward. Value Investors, take note!

Almost as a good as buyinh JNJ or BAC right now :-)

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