Nobel-prize winning economist Harry Markowitz wrote that “diversification is the only free lunch in finance”. A free lunch sounds good, but the reality is often bland sandwiches, a plate of crisps and lukewarm coffee. Private investors do not need to diversify as much as they think.
Diversification is conventional wisdom. The idea makes a lot of sense: by diversifying across a broad range of assets an investor can reduce both risk and volatility. For those who are risk-averse or are coming to their autumn years, this strategy can certainly help one sleep at night.
However, everything in life is a trade. Reduced volatility means downside is protected, but upside is diluted. And when it comes to risk reduction, although specific asset risk is reduced it doesn’t matter how diversified you are in a bear market. Nearly everything falls. I believe private investors are sold diversification as a hedge against downside risk. But they can achieve similar hedging through buying a smaller number of non-correlated stocks, without stunting their upside.
Diversification is pushed by fund managers who manage capital and need to cover their bases. This is because their goal is often not to lose money, and the best way not to lose money is to be risk averse. Plus, institutions often have a lot more capital to manage than private investors. Unless you wake up one morning and find that you’re suddenly a multibillion hedge fund, diversification does more harm than good.
This is because not all stocks are created equal. Indeed, some stock ideas are better than others. But if you were to follow conventional wisdom and buy 20 stocks equally then your best idea would be worth five per cent of your portfolio — the same percentage as your worst idea. Diversification, then, is a protection against risk. Specifically, it’s a protection against things you don’t know and can’t control.
The UK small-caps market is both illiquid and inefficient. The Aim index is full of companies that are under-researched and overlooked. That said, the FT reported that in the first 20 years of Aim, investors would have lost money in 72 per cent of all Aim companies. Roel Campos, a former member of the US Securities and Exchange Commission, once famously called Aim a “casino”.
But his viewpoint on Aim stocks actually works in favour of the private investor. For those hunting multi-baggers (shares that multiply the original investment), Schroders found that the UK was a more fertile environment than the US. This is despite America having a reputation for the more exciting stocks.
UK small-caps often present asymmetric risk/reward opportunities because this part of the market is unloved. It’s this opportunity that private investors should be attempting to capture, and not diversifying because they’re led to believe they need wide exposure. Focusing on the best ideas yields better results. As private investors, we also have several advantages over our professional counterparts.
First, we have position agility. That means we can buy and sell stocks with relative ease. For institutions, the buying and selling of a position can take weeks and drag the price up or down accordingly. Being able to move fast is a great advantage.
Second, institutions have to diversify under their rules. Private investors have full discretion over their holdings. I would never suggest piling all of your capital into a single stock, but owning five to 10 stocks focuses your capital on your best ideas. But it also provides you with enough diversification that if one stock suddenly delivers a financial shock (it happens) then you don’t take a knockout blow.
Private investors can also diversify by buying stocks that are relatively uncorrelated to the market as a whole. FTSE 100 stocks and large caps find themselves beholden to macroeconomic conditions, whereas small-cap stocks can deftly navigate storms. That doesn’t mean they always do — but by owning stocks that aren’t correlated you diversify against systemic risk.
For example, you might take the view that a small-cap tech stock can grow because it’s financed for the next year and macro conditions won’t much affect it. This stock will have little correlation to, for example, a small-cap oil producer.
The trick for private investors is to seek opportunities where the reward payout more than compensates for the risk taken, and to own a selection of these stocks across various sectors. This approach requires commitment of time and effort — perhaps more so than a portfolio containing lots of stocks. But anyone picking their own stocks, no matter how diversified they may be, should already be committed to keeping tabs on financial markets and ready to deal on any trading day. This is an unavoidable cost of not outsourcing your investing.
My belief is that investing in 10 well-researched and uncorrelated stocks is well diversified and allows a chance for growth.
Once you go over 20 stocks, you start to correlate your holdings significantly with the very index (and money managers) that you’re trying to beat. You may scatter your bets but this comes at a cost: your attention. Can you be an expert on 20 stocks at once?
If you want to diversify, then buy an index fund. They outperform most money managers preaching diversification. The fees are cheaper too. How’s that for a free lunch?
At best, diversification protects against sharp downwards volatility from one stock. At worst, it robs private investors of the chance for spectacular (and achievable) gains.
Choose wisely, because the decisions you make on portfolio allocation can be seriously harmful for your wealth.
Michael Taylor is a trader of his own capital and founder of trading education website shiftingshares.com. He has long and short positions in Aim and main market London Stock Exchange securities
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