The case for a Diversified Portfolio

As a counterbalance to the recently started Creating a Concentrated Portfolio thread, we were thinking of introducing the case for a Diversified Portfolio. Akshay has very nicely introduced the context. There is a strong case for diversified portfolio as well, especially in early learning phases.

Let’s try and argue both sides of the coin, to maintain that essential balance and become better at what we do.

Posted byAkshay Jainat Monday 19:22

I am reminded of a couple of investment maxims here, both essentially meaning the same

1). Goal of investment is first return of capital and then return on capital

2). To finish first, you must first finish

Now if we see ourselves as investors for the very long term, we must first ensure and do everything in our power that we don’t do anything that will affect our ability to participate in the game we all love. A 15% to 20% CAGR return over a long period of time will ensure enormous wealth creation in any case. Firstly by concentration, I am referring to portfolio with maybe 3-5 stocks. As buffett says, If he was to restart his investment game with a small sum, he would go super concentrated. And as the sum increases, incremental diversification should be considered. Another view, that of Lynch is that he would recommend participating in as many stocks as he sees a clear opportunity, as he feels that his returns should be based on him being an investor who understands value and quality of businesses as a whole and not on the fate of a particular stock that would possibly have a 25%-50% concentration.

The way I see it, super concentration should be considered only by individuals who have immense faith in their abilities and are original thinkers. Past performance track record over bull and bear cycles should help. Sometimes people tend to want to emulate concentrated portfolio’s of their seniors/mentors, being sold by their ability to elaborate on why their stock picks make a lot of sense. This can be very dangerous as in the long run, money cannot be made on borrowed knowledge and conviction

I think one should increase concentration with time, performance record and experience. Until then some diversification will ensure you survive to learn from your mistakes.

How much of Diversification is just right?

I have always thought/found just as Concentration is a double-edged sword, so is Wide Diversification.

I used to have close to 30 stocks in my Portfolio in 2005-2008, when I was a passive investor. I have seen this kind of over-diversification actually hamper the investment results of a bright stock-picker (pardon the indulgence) by limiting the size of each individual stock position.

When I turned active Investor from 2009 onwards, I pruned my portfolio down to 15 of my own accord and saw big improvement in results.

I had read somewhere that Modern Finance theory acknowledges that on an average 85% of the available diversification is achieved with a 15-stock portfolio. This increases to 95% with a 30-stock portfolio. You do not/ can not reduce RISKS any further by investing in more stocks across more sectors was the widely held belief.

But the original studies have been updated. And I found atleast 2 papers that argue for higher diversification

1. How many Stocks make a diversified portfolio?

2). The truth about diversification by the Numbers

However intuitively I would argue anything over 25-30 stocks is probably way much over-diversification. As a serious investor if you have to resort to that it implies you just cant separate the Wheat from the Chaff or the Men from the Boys, you probably are better off with investing in the Index!And we have all seen what Index or widely diversified mutual funds have delivered in the last 3 years.

Which tells me - probably 15-20-25 stocks should be good enough, as an individual investor progresses at the art of stock-picking and capital allocation?

Over toexperienceddiversified portfolio guys.

Diversification can mean different things to different people

Some ways to diversify may be as under

1). Peter Lynch - All stocks can be divided into the following categories a. Cyclicals b. Stalwarts c. Turnarounds d. Fast-growers e. Asset plays - To him investors should consider diversifying with this thought

2). Based on market caps - Large, Mid, small, micro

3). Sector based

4). Promoter based - For example assume an investor is the owner of Godrej Industries, Godrej Consumer, Godrej Properties, Geometric - Is he really diversified?

I am sure there must be many more ways to classify stocks.

So my point is when we consider diversification, should we also ponder on the method we use to diversify and whether that makes sense. Or we may not be as diversified as we think

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Another benefit from having diversified portfolio is it Saves you from Negative Black Swans.

The kind of fall which Wockhardt, Titan (though it recovered), Yes bank, MCX have suffered recently can hurt the concentrated portfolio really hard.

And the falls were unpredictable in all the above cases (in my views atleast).

Good Point Akshay.

I do not subscribe to diversification across cyclicals, stalwarts, fast growers, turnarounds, etc. for obvious reasons. Thought Peter Lynch introduced the 6 different classifications for us to recognise and slot them as such -when we come across a new idea. Not sure he actually advocated diversification across the 6 types.

If I speak for myself, I will introduce diversification in my Concentrated Portfolio - to bring in Stability. For me that kind of stability (to balance the aggression in excellent but small and midcap businesses, in the face of a secular fall in markets) can only be delivered by FMCG/Branded/Pricing Power perennials.

I will look to lend some much needed stability with some core FMCG/branded consumer/pricing power businesses. ITC I have held since 2005 and has been giving me 25%+CAGR. Will look to bolster that with 2-3 more core holdings - Page is a leading contender there - it expensive as the leading FMCGs, but its growth consistently much higher; but the best part is its record on Return on Incremental Capital in last 1 yr, 3 yr or 5 yr periods is amazing - and beats all of the usual heavyweights hollow!

Need to go back to the FMCG Branded study we had initiated a few months back for more well-chosen ideas. I am not comfortable with any financial sector compounders till such time there are revival signs in the economy. So the likes of HDFC, HDFC Bank or Gruh are out.

Good Point Jatin- and for me the most convincing argument raised in favour of diversification:).I have thought about this often, and I always come back to the Basics.

Diversification gives that much needed balance. But as Akshay says, the diversification strategy has to be clear and unambiguous, for it to be effective. I must know what Risk am I really diversifying away in my Portfolio! Is it Company Risk, Industry Risk, Market Risk, or may even be common Promoter Risk as Akshay pointed out -for a specific Portfolio.

1). No matter what I do, I have to be prepared to pay some Tuition fees to Mr Market (as Hitesh pointed out again recently).

2.Risk and Reward go hand in hand. For higher Returns, I have to take on higher Risks. Portfolio to Portfolio Risks will differ. I must think specific to My Portfolio.

3). Think hard about - What is my Portfolio Stability plank (Market Risk - in times of secular falls).

4). Ensure ALL portfolio contenders - Must PASS Strict NO-NO Company Risk Mitigation filters

And then I have to swing hard when opportunity beckons - because I am in the Market for higher Rewards, not otherwise.

** Saves Swans. **


Really great insights. How does one factor in volatility in the portfolio (based on an individuals tolerance level and time horizon?). Is there a way to benchmark portfolio volatility scores over a period of time? (Avg Mean/Std Deviation maybe?).

The two factors i have considered so far are Industry segmentation (Discretionary, Export led, B2B/B2C, defensives etc) and a market cap segmentation.

Donald - liked your point about stability being provided by defensives like FMCG.

Akshay - Good point.


Disc: I have 12 stocks in portfolio.