Monday, October 02, 2006

Principle #18 - Diversification Is Mostly Good

Diversification is a concept that many people like and a minority of people hate. Who is right?

There are plenty of academic studies that show that diversification reduces risk. Diversify enough and the risk to your portfolio is reduced. The greater the degree of diversification the greater the reduction in risk (although the benefit starts to drop off quite sharply after a relatively modest degree of diversification). This makes sense. Take a portfolio of shares as an example. If the portfolio (Portfolio A) consists of a single share and that share goes down in value (even to zero) the portfolio will go down by the full amount of the loss on that one share. However, if the share only represents one out of ten shares in a portfolio (Portfolio B) , then Portfolio B will only lose one tenth as much as portfolio A (assuming equal weighting).

Diversification is a good risk management tool.

However, diversification comes with a price. Each addition to a portfolio has at least three things going against it:

1. Cost. Depending on how you hold your investments, fees and charges may be incurred for each position that you hold. The more positions you hold the greater the costs;

2. Time. Each investment takes time to research and time to monitor. Adding to your investment portfolio reduces the amount of time you can spend researching each investment before parting with your hard earned cash and the amount you spend monitoring each investment. This increases both the risk that you will make bad investments and the risk that you will fail to exit losing investments on a timely basis;

3. Quality of investments. Investors will pick the best investments for their portfolios first. By definition at a certain point additional investments have to be less attractive than earlier additions to the portfolio. It has been famously described as "diworsification".

There are plenty of very real case studies that show that having a relatively small number of investments in a portfolio can result in returns which exceed those available by investing in the market as a whole (index returns). History is also littered with examples of people who failed to adequately diversify their investments with spectacularly awful consequences. Barings (Nikkei futures) and Amranth (natural gas) are two of the better known examples of risk concentration going wrong.

The traineeinvestor is an individual who is in paid employment with a limited amount of time to spend on his investments. He is also unwilling to risk significant loss on his investments - significant losses or even inadequate returns will delay his departure from the ranks of those who are forced to work for a living. Diversification is an essential tool to overcoming both of these limitations.

At the same time he must be conscious of the risks of taking diversification to excess. Max Gunther got it right when he said that diversification protects you from the risk of just about everything - including the risk of being rich.

1 comment:

makingourway said...

I have to credit Trainee Investor with being a brave soul.
He never flinches when addressing topics of contraversy.

I posted a detailed discussion of this article over at my blog. You can see it here.

Kudos to Trainee for bravely tackling a topic full of contraversy and letting the conflict thrive!