I recently read this quote from Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah. Granted, I have never met, nor have I had any conversations with Mr. Israelsen, but he seems to be a competent professional. According to his bio, he is an executive in residence in the personal financial planning program in the Woodbury School of Business at Utah Valley University. However, his statement still bothers me a bit, as he is saying that any other investment approach must be insane.
Gerald Loeb rose to fame in the 1930’s from his work with E.F. Hutton and from his book, The Battle for Investment Survival,first printed in 1935. Loeb was a media darling following the great crash of 1929 and shared his thoughts in short and simple phrases. When it came to diversification he said “The greatest safety lies in putting all your eggs in one basket and watching the basket.” He also laid down his thoughts on asset allocation:
I think most accounts have entirely too much diversification of the wrong sort and not enough of the right. I can see no point at all to a distribution of so much percent in oils, so much in motors, so much in rails, etc., nor do I see the point of dividing a fund from a quality angle of so much in “governments,” and so on down the list to that so called very awful, speculative, non-dividend-paying common stock.
In the year before Gerald Loeb’s book was published, Benjamin Graham and David Dodd published Security Analysis. This book became the bible for the new field of security analysis, but it wasn’t until Graham’s book The Intelligent Investor was published in 1949 that individuals were exposed to the concept of value investing. Graham, unlike Gerald Loeb, saw the benefits of asset allocation for the conservative investor. He said, “The other side of the coin shows the advent of common stocks as an integral and important part of a sound investment program. The proportion of the total funds to be placed in common stocks will now range ordinarily from say, 20 percent to as high as 50 percent.”
In the last edition of The Intelligent Investor,he added this statement concerning the number of companies held in a defensive portfolio of common stocks: “There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.”
Richard H. Jenrette
In 1964, Dick Jenrette, a leader in the creation of standards for institutional investors and founder of Donaldson Lufkin Jenrette, the first publicly traded investment firm in the country, shared his views with the New York Society of Security Analysis in Portfolio Management: Seven Ways to Improve Performance. This is what he said regarding portfolio diversification:
Over-diversification is probably the greatest enemy of portfolio performance. Most of the portfolios we look at have too many names. As a result, the impact of a good idea is negligible. Moreover, the greater the number of companies in the portfolio the more difficult it is for the fund manager to stay on top of developments affecting these companies. In our opinion, 25-30 companies is enough diversification even for a fund of $100 million. For a $1 million portfolio seeking to outperform the market, we believe the number of holdings might be as low as 10-15. We have yet to find an institutional investor who had more than 10-15 investment ideas that he really liked at a given time.
As we skip forward a couple of decades, a famous investor most of us know, Warren Buffett, had this to say about diversification: “Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” He has also said “I can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things.”
As to the benefits of risk reduction due to diversification, he shared this in his 1993 letter to shareholders:
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”
Jim Cramer, the wildly popular host on CNBC’s Mad Money, is no lightweight in the world of influencing investors. He is a magna cum laude graduate of Harvard College and the author of several very successful books on investing. He claims that as a hedge fund manager he produced an average annual return of 24% for the 14 years he managed the fund.
A portion of Mad Money shows are often set aside for individuals to call and share with Cramer their own portfolios, asking the question “Am I diversified?” It seems that Cramer answers yes if the individual owns five different companies from three to four industry groups. Cramer also freely publishes his holdings in his charitable trust. The trust as of this writing holds 28 companies. It looks as if Cramer, according to his comments on his show and his own charitable trust, agrees somewhat with both Benjamin Graham and Dick Jenrette.
I have hand-picked these comments on diversification from active and very successful investors, and we should add some thoughts from Nobel Prize winner Harry Markowitz. In 1952, young Markowitz authored a short academic paper titled Portfolio Selection. This paper could be considered “the shot heard round the world” for the portfolio management industry. His thoughts led to modern portfolio theory and firmly entrenched the use of technology into the practice of investment management. This paper and the ongoing research it created was the driving force behind the idea that “Building and staying with a broadly diversified portfolio is the only sane approach for long-term investors.”
His paper starts with a description of the process that the majority of investors, both professional and non-professional, apply when building an investment portfolio:
The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of portfolio.
He goes on to explain the purpose of his paper:
This paper is concerned with the second stage. We first consider the rule that the investor does (or should) maximize discounted expected, or anticipated, returns. This rule is rejected both as a hypothesis to explain, and as a maxim to guide investment behavior. We next consider the rule that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing. This rule has many sound points, both as a maxim for, and hypothesis about, investment behavior. We illustrate geometrically relations between beliefs and choice of portfolio according to the “expected returns-variance of returns” rule.
This basic concept is valid for most of us. Each of us would like to have the greatest rate of return we can, with little risk of loss. Yet most of us know that very little gain is likely without accepting the potential for a loss. How much risk each one of us is willing to take is relative to our own individual situation. Markowitz appreciates this, but the ability to measure everyone’s risk acceptance is near to impossible, so he substitutes historical volatility as a measure of risk.
The ups and downs of the overall market value surely drive many people to join the age old “buy high sell low club.” Diversification does not, nor will it ever, protect one against the volatility of market prices. However, a portfolio of two different investments, both of which have market volatility that differ from one another, would reduce the overall ups and down of the total value of the portfolio, as long as one went up in value and the other went down in value at the same time. In other words, diversification by itself will not protect you against market risk, unless it is the right kind of diversification.
Markowitz addresses this:
Not only does the E-V hypothesis (Expected Returns-Variance of Returns rule –added by me) imply diversification, it implies the “right kind” of diversification for the “right reason.” The adequacy of diversification is not thought by investors to depend solely on the number of different securities held. A portfolio with sixty different railway securities, for example, would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sorts of manufacturing, etc. The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries.
I believe that almost every investment manager thinks there is some benefit of diversification. Most portfolio managers, if given a choice, would apply the ideas of Dr. Markowitz to their trade. Some will place more emphasis on their ability to determine “future performance,” while others will pay little attention to future performance and instead hope to receive the “free lunch through diversification” as promised by modern portfolio theory. Our beliefs are at the intersection of these, where we rely on our ability to calculate an expected rate of return and attempt to apply the “right” type of diversification in order to meet individual needs. In essence, we want to own the fewest number of companies we can to obtain the excess returns available from superior analysis, yet spread between all major economic sectors of the world economy.
As far as the number of companies, we believe that 30 to 40 are the most needed to minimize the impact of a large loss on a single company on the overall portfolio, yet also few enough where a large gain on a single company would materially increase the overall portfolio return. There is a little common sense to this: If you have 40 companies, with each representing 2½ percent of your portfolio, the portfolio can only lose that 2½ percent if a single business fails. At the same time, a single company could, if all things were perfect, produce unlimited profits.
To add a little historical certainty to this, all we need to do is compare the annual volatility of the Dow Jones and its 30 individual companies with the annual volatility of the Standard and Poors (S&P) and its 500 companies. The annual average volatility is almost identical over a long period of time. Even in short time periods, the average volatility is close. If we look at the last five years, the standard deviation (a measure of volatility) of the S&P 500 was 13.96 while the Dow Jones Industrial Average was 12.94, so little of a difference that it would probably not be noticed by the vast majority of investors. The Dow is price weighted, and the S& P 500 is cap weighted, so you could make the claim that I am comparing apples to oranges. However, if I took the view that diversification alone should reduce volatility, then the S&P should be far less volatile than the Dow – but it’s not!
Standard & Poors also does each of us a favor by identifying and affiliating the majority of publically traded companies into ten major economic sectors. By owning a representative position in each of the ten sectors, you can obtain the “right” kind of diversification as mentioned by Harry Markowitz in Portfolio Selection.
We started this letter with Craig Israelsen’s comments on portfolio construction. According to him, the “only sane approach” for long-term investors is to build and keep a broadly diversified portfolio. He suggested equal weighting of seven asset classes; large and small U.S. stocks, non-U.S. stocks, commodities, real estate, U.S. bonds and cash. This may work out fine, but are you willing to take the chance that future returns will be the same as they have been in the past?
I have seen countless portfolios constructed that emphasize asset class diversification only, without any determination of expected returns. This may reduce volatility, as many claim, but all of us invest to make a positive rate of return. Because of that, I believe that the first step to any successful investment program should be to calculate an expected return, even though it will not always be right. We diversify for this reason only. Our goal is to maximize after tax profits for an acceptable level of risk. To reach our goal we need to have some estimate of both our expected returns and the risk we take. If that is insane, so be it.
Until next time,
Kendall J. Anderson, CFA