Just this week I came across a remarkably perceptive study performed by a rare sub-group of investing professionals who dare to deviate from the norm and in fact question some established mantras such as the untold benefits of diversification.
http://www.advisorperspectives.com/newsletters09/pdfs/Why_Diversification_is_Failing.pdf)
Messrs. Page, Chao and Kritzman provided empirical evidence to confirm something I had long suspected but had never “proved”. Diversification across asset classes, geographies or even investing styles (think growth vs. value) is least useful when it is most required. Indeed correlation is highest on the way down rather than on the way up “depression is more contagious than euphoria". To cap it all historical evidence dating some 30 years (more than enough to encompass secular trends and a number of boom-and bust cycles) indicates that such a policy actually stands in the way when times are good, providing a metaphorical umbrella just as the sun comes out.
Once again, as was the case with Efficient Market Hypothesis and its (dire) implications for its most ardent followers financial academia provides us with just the sort of advice you don’t need.
(see previous post on the irrelevance of beta in measuring risk - http://www.juliovildosola.com/2009/11/are-investing-odds-stacked-against-us.html-)
Putting together a rational investment portfolio seeking to minimise standard deviation and yet maximise risk, (in what scholars refer to as the “efficient frontier”), would likely require a number of securities that no one investor could reasonably oversee, not to mention the fact that standard deviation has little to do with actual risk!.
With the exception of the legendary Peter Lynch who managed to deliver stellar returns whilst overseeing a fund with many hundreds of names, I know of no successful investor whose fund comprises more than 50 positions. Given that profitable investing is to be performed in business-like fashion and stock holdings are but partial ownership claims on operating concerns, it should be apparent to all why managing a large number of positions is anything but manageable!. Most notable value investors have been known to hold between 5 and 10% of their fund on a single security. None other than Warren Buffet made news from his remarkably lucrative foray into Amex in 1964 which at the time represented some 40% of his partnership’s funds!.
Having said that, what do most professionals prefer? You guessed right!, large baskets of stocks in an attempt to diversify risk or more subtly, to approach the average-return seeking of index-replicating ETFs or mutual funds. It’s terribly ironic however though that these “professional” investors charge up to 2% of annual fees for the “privilege” of spreading your money across a number of under-researched and yet mostly over-bought securities. When you consider that surely better returns can be obtained at a fraction of the price (around 20 basis points of annual fee for index funds)… I think you get my point.
Whose interests are being served in this manner? Numerous positions more than likely entail portfolio rotation, trading costs, and large teams of analysts; in short, they serve to perpetuate an industry that feeds on itself!. There’s not much marketing spin that can be put out to hype low stock turnover and patient value searching. Furthermore, an additional unacceptable consequence can be pointed out for blame in this seldom enforced concentrated investing approach, as being fully invested is not an obligation.
When the real costs of a fully invested position are tallied up, eg. Liquidity shortfalls to meet redemptions or reduced capacity to invest at short notice on brief windows of opportunity caused by temporary market dislocations, the shortcomings of an over-diversified or fully invested position are there for all (who may want to) see.
As Mark Twain once said,
Put all your eggs in the one basket and --- WATCH THAT BASKET
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