Thursday, December 3, 2009 2 comments ++[ CLICK TO COMMENT ]++

Portfolio diversification

Jason Zweig, whom you may remember as the editor of the latest edition of The Intelligent Investor, writes a good series for The Wall Street Journal called The Intelligent Investor. It's generally avaiable for free so I check out his articles once in a while.

Zweig appears to be a passive investor; I'm an active investor. Like most passive investors, he also favours wide diversification; in contrast, I'm trying to master concentrated investing. So, I really don't agree with most of what he says and don't find his articles aligned with my thinking. But I still read them for a reason: Zweig generally throws in some unique insights or results of some academic research that is worth pondering regardless of the investment strategy you are pursuing. His article from November 26th is one such case. In it, he mainly talks about how wide diversification is the best strategy and I don't share the same view. But he also mentions something interesting (as usual edits such as bolds are by me):

Don Chance, a finance professor in the business school at Louisiana State University, asked 202 business students to select one stock they wanted to own, then to add a second, a third and so on until they each held a portfolio of 30 stocks.

Prof. Chance wanted to prove to his students that diversification works. On average, for the group as a whole, diversifying from one stock to 20 cut the riskiness of portfolios by roughly 40%, just as the research predicted. "It was like a magic trick," says Prof. Chance. "The classes produced the exact same graph that's in their textbook."

But then Prof. Chance went back and analyzed the results student by student, and found that diversification failed remarkably often. As they broadened their holdings from a single stock to a basket of 30, many of the students raised their risk instead of lowering it. One in nine times, they ended up with 30-stock portfolios that were riskier than the single company they had started with. For 23%, the final 30-stock basket fluctuated more than it had with only five stocks in it.

I haven't looked at the study being quoted but it appears that risk is being measured based on volatility (i.e. standard deviation.) If so, that's not my view of risk but let's not quibble over definition of risk because that's not the main point.

The key point I wanted to highlight is how the overall average of a set of investors may appear as one thing (in this case, low volatility/risk) while individual investors experience something completely different (in this case, high volatility.) This is something that is very important for you to consider if you diversify heavily, look at quantitative studies (or follow quantitative strategies) or do a lot of back-testing. Studies may concluce, almost always based on overall averages, one thing but it may turn out to be different for individuals.

Why does this happen? Zweig presents some theories:

What accounts for these odd results? Leave it to a professor called Chance to show that even a random process produces seemingly unlikely outliers. Thirteen percent of the time, a 20-stock portfolio generated by computer will be riskier than a one-stock portfolio.

Humans are even more fallible. Prof. Chance's students started by picking companies they were familiar with: Exxon Mobil, Wal-Mart Stores, Apple, Starbucks, Nike and the like. But after a handful or two, they ran out of household names. By the fifth company, they were picking stocks that had less than half the market capitalization of the one they started with. Adding these riskier small stocks made their portfolios more volatile. And one in five students picked as a top holding, perhaps because Prof. Chance happened to schedule the assignment near Valentine's Day, when they may have had bouquets on their minds. (They weren't just picking from the top of an alphabetical list; almost nobody chose 1-800 Contacts.)

These results are no surprise to Allan Roth, a financial planner at Wealth Logic in Colorado Springs, Colo. "Humans can't think randomly," says Mr. Roth. "Once people think of Exxon Mobil, they're a lot more likely to think of Chevron or another oil stock. For a lot of investors, diversification is like doing a word-association game."

Gur Huberman, a finance professor at Columbia University, points out that investors tilt toward stocks that match their own beliefs about risk. People who regard themselves as risk-averse will assemble portfolios of highly similar stocks that all seem to be "safe." The result, paradoxically, is a risky portfolio with every egg in one basket. As bank-stock investors learned last year, owning a greater number of the same kind of company isn't diversification at all.

So, according to one professor, the flaw seems to be the complex pattern-matching out brain pursues. The prof suggests the notion of "pattern matching" which is very common in human behaviour. In other words, we may perceive an investment as random when in fact it isn't.

The second theory being put forth by the other professor revolves around people sticking to their perceived risk profile and inadvertenly concentrating in certain industries. As newbies, like me, know full well, risk is the hardest thing to analyze. What one perceives as high risk may not be so; and vice versa. The example cited with financial stocks is a good one. The vast majority of investors would have considered financial companies to be rock-solid and safer than, say, wildly fluctuating technology companies like Amazon or Ebay. Yet, the low-risk financials turned out to be a disaster.

I purposely don't diversify but even with the few stocks that I contemplate investing in, I worry about issues like this. Namely, I am always worried that I'm unconsciously biased in some way. One's circle of competence (knowledge, interest, etc) will drive decisions but what about unconscious psychological decisions beyond that?

I don't delve into psychological issues pertaining to investments very much on this blog because I'm still in the newbie stage where I'm trying to figure out valuations, understand the nature of businesses, etc. But at some point, if I were to become a successful investor, I have to ensure that I overcome psychological weaknesses present in almost all humans. Being unconsciously biased is one such issue.

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2 Response to Portfolio diversification

December 9, 2009 at 10:10 PM

We all have confirmation biases, seeing them are a real challenge.

December 11, 2009 at 4:53 AM

Portfolio structure is argueably just as important as actual stock selection.

Personally, I like to run 20 to 25 positions.  This allows me to diversify across industries and countries, and still track my investments regularly.

Also, moderate size positions suit my personality.

The small cap companies I invest in sometimes exhibit wild irrational
 (or at least unexplainable) price movements.  If I have 5% of my money in a company that declines 40% for no good reason, then I am comfortable adding to that position.  Even if this turns out to be a mistake, it is not crippling, either psychologically or financially.

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