Portfolio management
Too much of a good thing can be wonderful
A finance professor at a highly regarded university recently tweeted a reply to me: “Holding 500 stocks will diversify away pretty much all that idiosyncratic risk.”
Investopedia says:
- Idiosyncratic risk refers to the inherent factors that can negatively impact individual securities or a very specific group of assets.
- The opposite of idiosyncratic risk is a systematic risk, which refers to broader trends that impact the overall financial system or a very broad market.
- Idiosyncratic risk can generally be mitigated in an investment portfolio through the use of diversification.
The conventional wisdom is that expressed by the finance professor. It is also said that a portfolio of 30 stocks will achieve some 90% of the diversification benefits that one would obtain holding the entire S&P 500 universe.
Compare this with the following written by Warren Buffett:
“…if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.” (Cunningham, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p79 (emphasis added)
These views cannot be reconciled
The problem originally came from academia. Academics taught a generation of finance grads. For the last 70 years the world of finance, including many money managers and investment advisors, has been hidebound by Modern Portfolio Theory which is the theoretical basis for the conventional wisdom on diversification.
Some background
In 1952 an academic study was made of diversification. Harry Markowitz carried out this work as a graduate student at the University of Chicago and ultimately earned a Nobel Prize. He showed that investment returns could be optimized for a given level of portfolio volatility through diversification. Volatility was thought to be the ‘undesirable thing’. Eventually, this undesirable thing morphed into risk as volatility came to be viewed as a proxy for risk. This allowed ‘riskiness’ to be measured. This ‘insight’ provided the mathematical basis for an approach to investing which came to be called Modern Portfolio Theory (MPT). For a given level of volatility a calculable amount of diversification would provide an optimum return – an efficient portfolio. Correspondingly, for a given level of return the efficient portfolio would produce the least volatility.
Some people think Markowitz ‘insights’ allowed investors to see the benefits of diversification. In fact, prior to Markowitz, investors had been diversifying for generations. His advance was to use statistical concepts to analyze and formalize diversification.
In my view, the ‘insights’ of Harry Markowitz led finance into a world where the emperor has no clothes.
There are four ideas contained within MPT. The first is that using measured negative correlation was a scientific way of building a balanced portfolio. (I am not qualified to comment on whether this facilitates creating a portfolio with natural hedges. I suspect it doesn’t, for the simple reason that they measure correlation between prices and not the underlying businesses.) The second was to build a portfolio with a group of stocks that exhibit negative covariance so as to reduce portfolio volatility. (Note, volatility may be undesirable to many investors but it is not a real indicator of risk.) The third was to posit that a portfolio with less volatility carried less risk. (This is not true for same reason). Fourth is the assumption that since higher returns necessarily come with higher risk, the MPT could be used as a risk management tool by measuring the volatility or deviation of the distribution. (This also is not true – A riskier investment will only provide a higher return if the return expectation is higher by a sufficient margin to more than offset the higher risk. The best way to increase return is through an edge. Investing in a riskier stock does not, in and of itself, produce a higher return. see here and see here)
The portfolio management program I use allows me to carry out a price correlation analysis on my portfolio. I never use it. Price correlation does not give a reliable indication of business correlation.
Along the lines of the quote from Warren Buffett above, it is far more direct and effective to reflect on the diversification and balance of a portfolio by thinking about the different industries or sectors represented, by the impact on their businesses of different input costs and the relationship of different international economies to each other and so on. If the price of some stocks in the portfolio go up and down at the same time, i.e. if the price action is correlated, this may or may not be the result of business correlation. It may occur for reasons that are of no concern to me.
How many stocks to hold?
As for the number of stocks to hold, the single dominant factor limiting concentration is the impact on a portfolio of catastrophic idiosyncratic impact on any one position. A catastrophic idiosyncratic risk is one that utterly destroys the value of an individual stock or holding. This might be a bank destroyed by a rogue trader, an oil company destroyed by a massive oil spill or a drug company destroyed by a product suddenly killing a lot of people.
Idiosyncratic risks that are catastrophic and also highly unlikely are also called fat tail risks. That is, from a statistical point of view, they are at the extreme margins of the distribution curve. Idiosyncratic catastrophic risks are risk that are highly unlikely. They may be risks you can’t imagine. They haven’t ever happened before.
The way I deal with these risks is through a limit on position weighting. This means a maximum individual stock weighting, at least for the writer, of 15%. If my favourite stock goes on a tear and reaches 15% of the portfolio, I will sell it down to 10% no matter how much I like the company.
Bottom line for me
I am all in favor of portfolio diversification and balance. Where I part company with MPT is when it is thought that a portfolio like mine can be developed and managed using mathematics and statistics. It is all too theoretical. It surely is better to be grounded in simple business ideas about balance and diversification. As for the ‘insight’ of using correlations or covariance to develop or manage a portfolio, again I am suspicious of the theoretical and lack of grounding. Correlations can change over time, sometimes quite quickly. I monitor business correlations quite intuitively in my portfolio by staying on top of business developments that affect my stocks. Finally, I completely reject the assumption that volatility is a measure of risk. I believe MPT gives false guidance when it suggests that one can reduce risk by reducing volatility. It encourages investors to attempt to build a low volatility portfolio when volatility is as natural as a succession of rainy/snowy days and sunny days at any time of year.
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To dig a bit deeper into diversification and balance take a look at the Motherlode Chapter 36. Diversification, balance and strategy
That chapter is divided into Sections with titles as follows:
36.02 Digression to idiosyncratic risks and unexpectables
36.06 An aside on industrial commodities and agriculture
36.07 Correlation and the business cycle
36.08 A sector rotation strategy
36.12 Thinking about currencies in the context of diversification
36.13 International diversification
36.18 Strategy for the individual investor
36.20 How many stocks to own – 1
36.21 Lessons from the world of gambling – betting your beliefs
36.22 How many stocks to own – 2
36.23 Conclusion – portfolio structure for the individual investor
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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