Buying shares: Diversification or de-worsification?

We continually hear the mantra from the financial services industry that we need to diversify, however I would question whether this mantra has become a myth that does not deliver on its intention.

When it comes to your investments, diversification in simple terms means to spread your capital across various investments in order to reduce your capital exposure to any one investment. While I generally agree with this theory, I find that at times the financial services industry takes it to the extreme. This can lead to ‘de-worsifying’ your portfolio. Let me explain….

Portfolio theory suggests that you should invest in different unrelated asset classes in order to spread or reduce your risk. This generally means to invest in shares, property or cash, with the aim being that when one asset class is falling it is reasonable to expect that another is rising. Again, I generally agree with this.

However, when it comes to investing in shares, the financial industry takes this theory to a new level by suggesting we invest in different sectors of the share market and to do so in many different companies. In my opinion this can be detrimental to getting good returns, as in doing this you ‘de-worsify’ your portfolio.

In my book How to beat the managed funds by 20% I share that in any investment there are two types of risk: systemic and specific.

Systemic risk relates to the risks associated with a particular investment market such as economic, government or industry. Systemic risk cannot be diversified and is inherent in any investment, and therefore the more you invest in an asset class, the more systemic risk you take on. For example, the more property you have, the more policy changes by government on property investment affect you.

Specific risk, on the other hand, can be diversified as it relates solely to the investment you are making. For example, if you invested 100% of your capital into purchasing BHP shares, then your risk is 100%. However, if you divided your capital into two shares – say, BHP and NAB –  then your specific risk is 50% for each company. Your systemic risk will remain the same as your total investment in shares is unchanged. If we take this theory further, and invest in five companies our risk equates to 20% in any one company.

While the above example is a simplistic view of diversification, the underlying principle is solid.

Research into portfolio theory suggests that the optimum number of companies that anyone should hold in their portfolio is between eight and twelve. With each additional company the reduction in specific risk is minimal, while systemic risk would continue to rise – resulting in an over-diversified portfolio. It is not uncommon for me to see share portfolios incorporating 25 to 50 different companies.

An investor with an over-diversified portfolio will, over time, find that about one third of their portfolio will be rising, one third will be falling and the remaining third will be going sideways, which is similar to the intention of diversification.

However, the catch is that you would not be investing in different asset classes, and your overall return would be market average at best. Therefore, a properly diversified portfolio holding fewer companies not only reduces risk and the costs of constructing and maintaining your portfolio, but it dramatically increases your probability of achieving above-average returns.

Let’s face it: selecting 12 shares that are likely to rise is much easier than finding 25 or 50. In my next article I will share with you just how to do that.