Tuesday, March 06, 2007

Diversification or diworsification?

According to Markowitz (he is a Nobel Prize Winner on Portfolio Theory), diversification is the only way to achieve a higher return at the same level of risk. This actually makes more mathematical sense than common sense, and most value investors do not subscribe to this thinking. Let's try to examine whether diversification is actually diworsification.

To paraphrase the essence of Markowitz's theory, basically it means that if you are only willing to accept the risk that you will lose, say 10% of your principal, and a portfolio of stocks and bonds can give you 8% return, the only way that you can earn more than 8% is to invest in other asset classes like commodities, real estate, bonds, private equity, integrated resorts, submarine fiber optic cables and credit card points. (Ok the last 4 are not socially accepted asset classes btw)

In order to achieve the maximum positive effect of diversification, the asset classes should also move in different directions, i.e. when one goes up the other should go down. This way, say if equity markets crack, hopefully bonds or commodities will still help to offset some losses. Ok we all know that's bullshit right?

Buffett and Peter Lynch (he is a star fund manager at Fidelity some time back, quite famous too) thinks diversification is bullshit too. Lynch calls it diworsification. This is bcos all of us have limited time and resources, and it does not make sense to try to invest in as many field as possible since we can only be an expert in only a handful of them. You should bet your entire net worth only when you find a potential ten bagger (a stock that will rise 10 fold) and only if you are damn sure. This way you maximize your effort in research, make money, feel happy and can go buy that Prada bag for your wife and that Ferrari for yourself.

I kinda think that the truth is again, somewhere in between. Diversification helps to a certain extent, but not as good as what is promised by textbook, but if you don't diversify, chances are that one basket that you put all your eggs will break. (Trust me, Murphy's Law works.)

As individual investors, diversification options are actually quite limited, we do not have access to some non-conventional asset classes like commodities and private equity. Most people will have to stick with bonds, equities and cash. Even so I think there are some benefits that could be reaped. E.g. by investing in stocks in the different sectors or different countries. You don't need a 100 stock portfolio to enjoy the benefits of diversification, the textbook says 30, personally I think anything more than 5 stocks should be good enough.

Of course, when the markets correct, like last week, correlation of all kinds of asset classes that you can think of goes to 1. i.e. everything will crack together, commodities, bonds, stocks, real estate, private equity, Toto, CoE, salaries etc. And diversification fails. But by and large, diversification should help to generate a better return for the same level of risk.

See also Efficient Market Hypothesis
and What is the Stock Market

CFD Diversity

Add diversity to your stock portfolio by trading CFDs. CFDs are margined products so a trader only has to put up a fraction of the cost of the stock. A trader can profit from both rising and falling prices in value if the right choices are made. A properly placed stop loss can help to manage any risk.
Post a Comment