Diversification is the one of the ways to reduce risk, or so we learned. While a properly diversified portfolio might reduce your risk of loss, it also lowers the chance you have to achieve market-beating returns.
If you are a value investor, you find that your approach already reduces your risk of loss without having to resort to various diversification schemes.
The Irony of Diversification
The idea behind a diversified stock portfolio is to hold enough stocks from different industries and sectors to reduce the risk any one stock or sector will decimate the value of your portfolio. Just as diversification works to reduce your risk by spreading out your portfolio, it also limits your upside potential as the math works against you. The more stocks you own the harder it is for the winners to overcome the losers. 91 percent of mutual funds underperform the market since they have the same problem, owning too many stocks for them to have a chance to beat the market.
What happens if your portfolio held four stocks and one doubled in price and the other three remained flat? You would enjoy a 25% increase in the value of your portfolio.
What if you held 10 stocks and only one doubled? Your return would be 10%. Still better than most portfolio managers. Hold 20 stocks and your return drops to 5%. The point is the more stocks you hold the greater chance you have to dilute the excellent returns of a few. Own enough stocks and you will achieve the market average before trading cost, that is.
On the other hand, holding many stocks in your portfolio reduces the potential you will suffer a loss from any one or a few stocks imploding. After all, the purpose of diversification is to lower the risk of a loss. The worse that can happen is the market plunges and your portfolio falls with it. That is where a diversified stock portfolio might not save you.
Since a diversified stock portfolio tends to match the market, you have little chance to beat the market. Then diversification reduces the chance that your portfolio will significantly underperform the market.
Reduce Risk the Value Investing Way
If you are a value investor, you search for quality companies that you can buy at a discount. When you buy a company at a discount, it lowers your risk of loss, especially if you have done your homework.
When you buy quality companies at a bargain, you reduce your risk of loss since you acquired each company at a bargain price. Value investors reduce their risk without having to own a widely diversified portfolio.
Value investors prefer to own a few quality stocks bought at bargain prices rather than owning a diversified portfolio of companies. Buying a stock well below its intrinsic value, allows you to realize a margin of safety that lowers the risk of a loss. Buying quality stocks at bargain prices lowers the risk of a loss without encountering the problems caused by a diversified portfolio.
In addition, when you understand a company deeply, you have a better understand of its strengths and weaknesses. This special insight gives value investors an advantage over those who follow the diversification strategy. Knowing a lot about 10 companies gives you an edge over an investor who holds 20 or more stocks in their portfolio.
The Bottom Line
Buying at a substantial discount and having a thorough understanding of the company you own, helps you lower the risk of a loss that is better than owning a widely diversified portfolio.
Value investors find success through their approach to finding quality companies. A widely diversified portfolio depends partly on the math of large numbers to help reduce risk. If you are willing to do the homework, your portfolio will thank you. Otherwise, buy a fund that matches the market. Just don’t complaint when the market remains at the same level for many years.
By Hans Wagner
My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/
Copyright © 2010 Hans Wagner
If you wish to learn more on evaluating the market cycles, I suggest you read:
Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.
Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling. One of the best, easy-to-read, study of stock market cycles of which I know.
The Disciplined Trader: Developing Winning Attitudes by Mark Douglas. Controlling ones attitudes and emotions are crucial if you are to be a successful trader.
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