KISS, diversification and balance

Portfolio management

Avoid the long salad bar

This post will be my attempt at a short, sweet, go at diversification and balance.

I will describe my approach to the subject in as few words as possible. Some ideas need explanation. Some can simply be listed and they speak for themselves. I will add a few words of explanation at the end for any readers still with me.

Balance is a different idea from diversification.

The first three bullets are repetitive on purpose.

Here we go

  • The particular importance of business correlation to proper diversification
  • Avoid thinking that price correlation has anything useful to tell us about diversification
  • Price correlation has little to do with business/sector correlation
  • A diversified portfolio will contain a variety of types of business risks
  • A diversified portfolio will contain companies with different business models
  • A diversified portfolio will contain companies at different stages of their evolution
  • Think about balance, natural hedging and the idea of building a team that works together
  • A balanced investment position will have opposed risks
  • 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. This causes a maximum individual stock weighting, at least for the writer, of 15%
  • A concentrated portfolio can achieve all the business/sector/risk diversification and balance you need
  • Simply adding more stocks does not achieve added business/sector/risk diversification
  • Put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes
  • It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence
  • One’s knowledge and experience are definitely limited
  • You need positions that will move the needle. As well, there are not that many superb companies
  • The companies in the portfolio and the economic sectors they operate in need to be followed closely. This is easier with a smaller portfolio
  • Just adding numbers of stocks to your portfolio will achieve neither diversification nor balance
  • Credit to Warren Buffett for most of the above

Words of explanation – Balance and hedging     

Let’s use interest rates to think about this. Interest rates affect companies, but not in the same way. To give our portfolio some balance it would help to find stocks in a sector that reacts differently to interest rates. Often what is bad for lenders is good for borrowers. The real estate sector which includes REITs, public commercial real estate companies, home builders, building supply stocks and so on, contains good candidates. They like low interest rates. When interest rates are falling REITs are able to renew mortgages at ever lower rates and their funds from operations improve even if they haven’t raised rents or increased profitability in other ways. In a rising interest rate environment things reverse.

In the falling interest rate environment banks’ interest rate spreads get squeezed more and more. In a rising rate environment spreads widen and, all other things being equal, profits improve.This would be an example of an inverse correlation, or hedging, between sectors. But, it doesn’t exist all the time. Real estate developers and builders tend to over build. When a recession comes along a number of players in the real estate sector go bust and the banks are left holding the bag. In that case both the borrowers and the lenders suffer.

To diversify our portfolio we might think of broadening out into life insurance companies. That really doesn’t help as life insurance companies are also sensitive to interest rates and in the same direction as banks. When rates rise both banks and life insurance companies do better. When rates fall, both banks and life insurance companies do worse.

What our little example has also brought out is the idea of natural hedging between different stocks in the portfolio. That is to say, if we want to own companies in the real estate sector but are worried about interest rates going up, we can hedge that risk by a position in banking stocks. If we own bank stocks and we are concerned about interest rates going down, we can hedge that position with real estate stocks but, we must recognize that both get hurt in a recession.

Balance between sectors

Our thinking can unfold like this: We know that we need to look at diversification across various sectors of the economy but also look at the balance and natural hedging between the sectors. Sectors we can look at might include: basic materials, communications services, consumer cyclical, consumer defensive, energy, financial services, healthcare, industrials, real estate, technology and utilities.

Beside traditional sector diversification one could include public companies of a different stripe such as those in the private equity business.

It should be clear by now that in constructing and managing our portfolio we need to consider business correlation between all the stocks in the portfolio. That is, in a portfolio of twenty stocks we need to think about the business correlation between the first stock and each of the nineteen other stocks, and then the business correlation between the second stock and each of the others, and so on. Not an easy task, but very important.

I’ve already mentioned banks. And we looked at the impact of one factor, interest rates. There are other factors that impact banks: regulation, technology, regional markets, competition and so on. In assessing business correlation between the banking sector and other sectors there is much more to consider than interest rates.

When try to construct and maintain a diverse portfolio with balance and natural hedging the situation becomes quite complex. That’s why a concentrated portfolio is easier and more effective.

A further illustration

As a further illustration, let us look at two examples in which input costs can affect margins. With the manufacturing sector, investors need to be alive to the impact of future increased energy or raw material costs on margins. With the transportation industry, investors should be aware of the sensitivity of the companies they invest in to fuel costs. Adding an appropriate weighting of energy or materials stocks will act as a hedge. If, on the other hand, the price of energy falls or if the price of materials fall, one’s industrial stocks will hedge that risk.

For each company in the portfolio we can look at correlation in input costs, correlation in prices to customers, correlation to technological change and correlation to currency movements and so on.

From this discussion the reader will see that mathematical models that show price correlation will give precise answers but they aren’t useful.


It is often said that diversification is a free lunch. A restaurant that only has a long salad bar with different varieties of lettuce will not give you a nutritious lunch.


If you like bullet points, check out these topics in the Motherlode:

27.01 Core ideas

27.03 Long term thinking

27.04 The economy

27.05 Superb companies

27.06 Company management

27.07 Homework

27.08 Value

27.09 Flexibility

27.12 Buying

27.13 Selling

27.14 Managing yourself

27.15 Managing your portfolio


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