The Unimportance Of Diversification

By | May 29, 2020

Diversification is the idea that owning stock of companies in different businesses, different sectors, and or different regions reduces the risk of a portfolio. While there are some extreme cases where diversification might prevent actual loss, the main thing diversification does is reduce volatility.

What is Risk?

Risk is the likelihood that you will make actual money or lose actual money from the purchase of a stock. Note that you do not gain or lose money until you sell a stock. It is possible that an individual company could file Chapter 11 bankruptcy, leaving your stock holding in that company worthless. That would be downside risk. Upside risk is the possibility that the company doubles in market value in the next year.

Companies do have problems and they do go out of business, but as an investor if you are paying attention, you can see when the company is accumulating debt or using up cash. That would be a good time to sell, and you would have a reason.

So what if you are caught by surprise and some infectious disease (Covid-19 perhaps?) kills off the whole travel sector, i.e. nobody is doing any business, and you own a whole lot of airlines? I guess you may have made a mistake by buying too many companies with the same business model… but if you buy the best of breed of airlines, and the best of breed of cruise lines, and the best of breed of car rental companies, what you bought should be able to weather the storm.

That may sound like diversification… but really what I am suggesting you do is buy the best companies. Diversification will probably happen, but it will be unintentional rather than intentional.

What is Volatility?

Volatility is more of a function of market prices. Market prices go up. Market prices go down. How far and fast they go up and down relates to an increase or decrease in volatility. Diversification tends to reduce volatility, making your stock portfolio easier to stomach. But it does not cause a literal gain or loss of money.

What I do when the market is being volatile is to recheck my assumptions about the companies I own. Do they have enough cash? Are they growing as expected? Are the dividends still being paid? If all assumptions are still good, I ignore the market price.

Unintentional Diversification

Diversification can be intentional or unintentional. I would say you generally pick the 10 best companies you can. Then as you come across other great companies, you can choose to replace an underperformer or not. But you don’t add a stock without subtracting another. Ultimately your companies will get better and better, hopefully. In the mean time, you just may have some amount of diversification. This is unintentional.

Intentional diversification, on the other hand, seeks to diversify a portfolio from the beginning, possibly ignoring great companies along the way and selecting underperformers. Maybe a whole sector is underperforming? Of course the reason not to do intentional diversification is the possible underperformance of your portfolio.

I generally invest in technology stocks. But I look at best of breed within certain business models. For instance, a company that makes most of its money from advertising; or a company that makes most of its money distributing products. Both companies are tech companies but they are not competing against each other directly. I would attempt to pick the best company that makes most of its money from advertising, and the best company that makes most of its money from distributing products.

In addition, I have also bought shares in companies that have nothing to do with technology. Just a couple. They are great companies in my opinion, regardless of their sector… but it did add some unintentional diversification to my portfolio.

Why Best Of Breed?

I have to say, I hear Jim Cramer of CNBC using this phrase all the time. But even before that, I learned that the first company to market is usually the market winner. After that, it is very hard to displace the market leader. Especially in an area, like technology, that has a barrier to entry. It costs a lot to create technology products and platforms. So why buy #2 when you can buy #1? Especially for the long term.

Buying best of breed companies does give you some unintended diversification, but the most important thing is to buy great companies at good prices.

Let me know your thoughts in the comments.

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