Diversification is a key part of any kind of investing, but practitioners differ on what exactly it means to be diversified. For some, it means simply selecting a broad basket of stocks that represent an index, without much consideration for what might unite them. For others, it means selecting complementary stocks that offset each otherâs weaknesses. Seth Klarman (Trades, Portfolio) is no stranger to this second mode of thinking, and his end-of-year letter from 1996 explains this point of view well.
What is real diversification?
No matter how much research you do, you can never be 100% right about everything. According to Klarman, this is why you should be somewhat diversified:
âA key component of our investment strategy is sufficient but not excessive diversification. Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely. These bargain-priced opportunities are selected one at a time, bottom-up, which provides a margin of safety in case of error, bad luck or disappointing business results. However, we are always conscious of whether these different investments involve essentially the same bet or very different bets.
If each of our holdings turned out to involve similar bets (inflation hedges, interest rate sensitive, single market or asset type, etc.), we would be exposed to dramatic and sudden reversals in our entire portfolio were investor perceptions of the macroeconomic environment to change. Since we are not able to predict the future (it is hard enough to understand the present), we cannot risk such concentrated exposures.â
This strikes at the core of what diversification is, and what it is not. Some people think owning many different companies in various cyclical industries is a type of diversification. It is not. If all of your holdings are exposed to the same systemic risk (recession), then it does not matter if they are diversified against various types of local risk (failure of any given industry).
Klarman also wrote:
âOwning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once. This is particularly true if that market is trading at record levels of valuation, supported more by money flows than by fundamentals, as happens sometimes (read âU.S. equity marketâ).â
For this reason, Klarman believes a well diversified portfolio must include a variety of different asset classes. Real safety, however, comes from doing good research:
âExposure to a myriad of markets and asset classes will mitigate certain risks that even broadly diversified exposure in a single market cannot. Of course, diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preference for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none.â
At the end of the day, the only thing that will minimize your risk is doing solid research into the fundamentals behind your investments. Diversification is a way of minimizing the impact of your mistakes, but that does not mean you cannot decrease the number of those mistakes.
Read more here:
- John Templeton's Investment Philosophy
- Howard Marks: Using Volatility as a Proxy for Risk Is Dangerous
- Warren Buffett: What Makes a Good Moat and What Does Not
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