A few days ago, the Wall Street Journal ran an article, Focused Funds Find Less Can Be More, highlighting the value of a concentrated investment strategy. It is a good, short article on the topic, but it misses an important point about diversification. The author writes, “Diversification is a tested way to control risk – a stock that represents 1% or less of a portfolio can’t inflict as much damage as a 5% position. Diversification’s downside is that it limits a fund’s chance to meaningfully outperform its index. Moreover, an overly diversified portfolio can mimic an index fund, but at a much higher cost.” The second and third sentences are certainly true, but the first leaves something to be desired.
It is mathematically correct that if a 1% position goes to zero the overall portfolio only loses 1% of value, whereas a 5% position could cause a 5% loss of portfolio value. However, a 100 stock portfolio may only be more diversified than a 20 stock portfolio in the number of company names it holds, as opposed to diversified from true risks. It comes down to what you are trying to diversify and why. Imagine recognizing in early 2008 that the financial sector was overvalued and significantly over-leveraged. If you built a 20 stock portfolio with no financial sector exposure based on this belief, your 20 stock portfolio would have significantly outperformed the 500 stock S&P500 index during 2008. True risk would have been diversified away.
Thinking about investment diversification based on number of investments alone is a mental crutch and a poor risk-management tool. One needs to look at a broad spectrum of potential economic factor risks (i.e. risks that can truly impact the intrinsic value of the security you own), as well as market risks and diversify exposure to the most likely and the most potentially harmful. A few examples of what we would consider relevant risks to diversify are: capital structure, inflation sensitivity, supplier, consumer, and legislative exposures.