Investing 101: Diversification

In constructing a portfolio, an investor might have to decide between a concentrated portfolio verses one with a more diversified mix. Here, I try to explain both sides of the coin, focused around arguments regarding why one should or shouldn't diversify. Readers can then weigh the points and decide on their strategy (if they haven't done so already).

I'll try to be as objective as possible, but there might be some opinion leaks, be careful!

What Does Diversification Do?

If done properly, diversification reduces the volatility of your returns. All else being equal, a diversified portfolio has lower potential downside, but it comes with a lowered potential return in general as a trade-off.

The reduced potential risks can differ, depending on how you choose to diversify. For example, picking multiple companies from the same industry (eg. DBS, OCBC, UOB) would reduce "internal" risks that are company specific - like fraud, or bad management. Diversifying across different industries would reduce sector risks (eg. some industries like airlines/tourism are hit harder during pandemics). 

Why should we always keep these risks in mind (and hence consider diversifying)? Some negative events are hard to rule out (there's always a non-zero probability of it happening in the future). 

Things like fraud and management issues slip through audits and checks from time to time, and is only obvious on hindsight. Things like pandemics are black swan events, which are by definition hard to predict.

How Much Is Enough?

Deciding the level of diversification is a personal problem. Should you allocated 50% of your portfolio to a company that you're convinced in? Or 25, 10, 5%? Ideally, you can diversify and reduce the level of risk to your maximum risk threshold. 

However, this threshold is hard to quantify. Here are some common guiding questions to determining your risk tolerance:

1. How much would losses in your portfolio derail your financial plans?

For a young working adult, much of the wealth accumulation would still stem from active income streams (eg. full-time job). As the investment portfolio is relatively small, suffering significant percentage investment losses would not derail the individual's long term financial goals too much.

For a retiree, there is typically little active income/job cashflow to fall back on, and the investment horizon is usually shorter. This makes investment losses hurt more, and carry more personal risk.

An extreme example to highlight my point here:

Imagine you found an investment/venture "B" that has amazing risk-reward ratio. Maybe, +100% potential gains with 95% probability and -100% potential losses with 5% probability.

Let's assume now that a retiree has $500,000 in a dividend portfolio, giving him 5% yield or $2,000 monthly to live on. He decides to go for 100x ratio venture, putting in all $500,000, as he assessed that it has better odds and potential compared to the existing dividend portfolio.

Is he wrong? Not really. The math checks out right? The odds are really in his favor, and mathematically going for venture "B" over the dividend play is pretty solid. However, when assessing risks, it is not just about the ratio/numbers itself. One should consider their life circumstances.

If it works out well, he stands to double his money, giving him $4,000 in returns if he reinvests into the dividend portfolio. If it does not turn out well (with a 5% probability), he loses it all, and would have to figure out another way to meet his daily needs.

In this case, he should account for his "low risk" stage of life, and factor it into his investment decisions. A better way to do things could be to put $250,000 into the venture, keeping the remaining as a dividend portfolio. This way, he stands to reap the upside (from a potential doubling of the $250,000 invested), but has a $1,000 a month dividend portfolio to fall back and live on.

2. Are you getting emotionally affected?

A large position in a company is exciting. A 5% gain over a few days could net $5,000 on a $100,000 position. However, it's just as common to see the opposite, with a $5,000 loss.

Having control over one's emotions, and hence actions, is paramount in sound, stable investing. If you find it too exciting, or get anxious about it to the point where it affects your daily routine/sleep, the position is likely too large.

Addressing Common Advice

It is common to hear from the community some suggestions towards new investors, along the lines of "start off with index investing first".

Are there merits to this? To answer this, let me elaborate on another mechanism that can reduce the potential investment risks.

And that is... get good! Now this sounds really stupid, but there's a reason why I mention this, so hear me out. If you noticed in the first diagram, increasing diversification reduces the length of the spectrum, which allows us to hit our personal risk threshold level. This spectrum started off symmetrical, and the reduction was also symmetrical. 

By getting "better", be it in terms of evaluating companies well, good strategies or whatever, one can break this symmetry. Hypothetically speaking, this means that "good" investors would have a lower investment risk, as he tends to make less mistakes in general. Note that there is lower risk, but the risks still exists - the black swan risks and stuff that we mentioned do no discriminate between investors of different calibre.

With a lower risk stemming from "better investing ability", "good" investors can thus typically afford to take on more concentrated positions, as they do not have to rely on diversification as much to reach their personal risk tolerance level.

So by that logic, and by the fact that most new investors will commit mistakes more often, I think the common advice to start off with index/passive investing makes sense from the risk management perspective.

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Thanks for reading till the end! This post and topic is quite contentious, and I have to emphasize again that this is just my take and opinion. Take it with a pinch of salt, do not solely use this as formal investment advice. Also, this post assumes that diversification is done properly.

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Cheers,

InvestingNugget