Diversification

Diversification is the process of investing in such a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. If the asset prices are not perfectly correlated, a diversified portfolio will have less volatility than a non- diversified one.

In other words diversification reduces risk. When investing in equities, investors approach diversification in a number of ways. Some believe that by holding a large number of stocks they can significantly reduce portfolio risk. Others believe there is an “optimum” number of stocks held which are not much riskier than the larger holdings. This number has long been the subject of debate with some practitioners believing that a portfolio can be adequately diversified by holding only 10-15 stocks.

In the late 1980s when I first started actively managing global portfolios, we held between 80-120 stocks and our peers had similar amounts. A few large fund managers might hold 150 plus. The result was often returns that at best outperformed the underlying index by 0.5-1.0%. It’s hard to significantly outperform an index when you own a large proportion of it. After fees the results were usually a bit ordinary. The search for higher returns led to the proliferation of “high conviction” funds and of course hedge funds, which grew exponentially during the 1990s.

Since then I have evolved into a high conviction portfolio manager reducing the number of stocks held to 50 (or less) and finally in my last roles at QBE and Perennial Investment Partners to 25 or less. I found that, assuming my stock selection was working, I could outperform the index by 3-5% pretty consistently. Fewer stocks (assuming they are the right stocks) can equal higher returns.

In holding a 25 stock portfolio, I was careful to diversify in three ways. I made sure that the portfolio was diversified by region, diversified by industry, and diversified by market capitalization. So while the portfolio was concentrated, I was not heavily overexposed to one geographic region, industry, or size of company (a portfolio of small companies is always more volatile).

Now at Macrovue we are constructing thematic portfolios of only 10 stocks. Why? For a number of reasons. First we are investing “thematically” not constructing a global portfolio. We believe 10 stocks adequately provides an optimal exposure to the theme. Second, we encourage Vue holders to be involved in their portfolios and offer the investor a chance to add (or subtract) companies from the Vue. (I know of no managed fund or ETF that offers this service.) Holding 10-15 stocks is manageable for the individual investor in terms of keeping track of their companies. 50+ holdings are not. Third, we believe we can obtain reasonable diversification from just 10 stocks by structuring the portfolio intelligently.

An example from our Disruptive Technology Vues

The challenge here is to find the most “disruptive” 10 companies but still provide a degree of diversification. In terms of geographic diversification it’s hard not to have a majority of holdings from the U.S., given the vast selection of innovative American companies.

 

Diversification by region:

diversification-by-region

Diversification by industry:

diversification-market-capitalisation

Certainly most are “Technology” companies but (and here is the key) many operate in different “sub industries” that are totally unrelated to one another! For example:

Diversification by sub-industry:

  1. Alibaba – Online retail
  2. Alphabet – Technology diversified
  3. Amazon Online Retail – IT services
  4. Arista Networks – Communication equipment
  5. Criteo – Software services / analytics
  6. Illumina – Life sciences / genomics
  7. Mobileye – Auto electrical / parts
  8. PayPal – Financial services
  9. Proofpoint – Software services / cybersecurity
  10. Tencent – Software services/mobile internet/gaming

Therefore the Disruptive Technology is diversified by region, industry and market capitalisation.

In our next series on Diversification we will discuss the advantage of purchasing several Vues and lowering the riskiness of overseas investing.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.