source: capitalideas
 

"One of the most common questions asked by investors has to do with portfolio diversification.  Most investors rarely are comfortable with the size and mix of their stock holdings and seek academic answers to guide them.  Regrettably, some have collected stocks like postage stamps and own shares in more than 100 companies.  They have become, for all practical purposes, human mutual funds.  Though such diversity makes them feel "safe," their portfolio's performance likely will never deviate much from the market's, though their net returns will suffer from high commissions.  In addition, they have doomed themselves to countless frustrating days of paperwork and of tracking cost bases, stock splits, dividends, and spinoffs.  What often gets lost like the proverbial needle in this haystack of responsibilities is performance.  No investor can possibly monitor so many companies with any true degree of diligence.  Sluggish stocks are likely to stay in their portfolios for years, overvalued stocks aren't sold at appropriate times, and these investors lose control over the ability to measure results.

DIVERSIFICATION IS NOT NECESSARY

The cause of this dilemma—modern portfolio theory—is not new; it dates to research conducted in the 1950s and 1960s that tested the possible returns investors could expect from holding various baskets of stocks.  In attempting to "minimize risk," researchers tested how individual stocks reacted to movements in the market and used mathematical principles to show that a portfolio's volatility, its up and down fluctuations could be controlled by carefully selecting stocks that moved counter to one another.

These mathematical quests led to the general theory of diversification: Buy stocks in different industries to ensure against their all declining at the same time.  Eventually, researchers concluded that while an investor could never eliminate a portfolio's volatility, she can minimize it by owning about 20 stocks.  Buying more than 30 stocks provides negligible benefits.  But with 20 stocks, academics argued most individuals were "practically" diversified.

What does it mean to be diversified? A properly diversified portfolio, in academic parlance, is one that eliminates nonsystematic risk, that is, the risk that a single stock can cause material disruptions to your portfolio's returns.  The theory held that if you combine 20, 30, 40—even more—stocks in a portfolio, you could eliminate the risk that one stock imploded and caused your entire portfolio to suffer.  For every stock that unexpectedly declined, you could expect one to rise and offset the loss.

But being well diversified never protects your portfolio your portfolio from losses.  Even the most well managed mutual funds that own 200 stocks or more lose money periodically.  Having so many stocks merely lessens the probability of loss, a distinction that is important for all investors to understand.  An investor always is vulnerable to systematic risk, the risk that an unforeseen event can cause the entire stock market to drop.  No amount of stock buying can reduce all systematic risk.  The best you can do is to spread your money into different instruments such as bonds and foreign stocks to insulate yourself from a stock market meltdown.

Indeed, many investors have learned the hard way that owning 20 stocks alone won't necessarily reduce their risks.  Many investors believed they were diversified in 1994 because they owned one dozen or more utilities and all the "Baby Bell" stocks.  They learned the hard way the herd rule: Like stocks fall together.  Indeed, when the stock market plunged on October 19, 1987, nearly every stock listed on the New York Stock Exchange, American Stock Exchange, and Nasdaq dropped in price.  On the surface, it seems improbable that nearly every public company could fall in one day or that they were suddenly worth less intrinsically, but decline they did.

In fact, later research has found that even 20 stocks are insufficient to achieve diversification.  If you want to ensure that your portfolio returns do not deviate much from the market, you might have to own 60 to 100 stocks, a financially impossible task for most investors.

Risk cannot be defined by mathematics or share-price movements.  Rather, investors create risk by chasing stocks indiscriminately, by failing to do their homework.

But to a value investor, blanket statements about risk and return, which may have meaning at the billion-dollar money management level, are inert.  Risk cannot be defined by mathematics or share-price movements.  Rather, investors create risk by chasing stocks indiscriminately, by failing to do their homework.  You encounter the biggest risks when you fail to evaluate a company properly and as a result, pay more per share than the company is truly worth.  A company purchased at $60 per share offers a compelling value and little business risk if the shares actually are worth $90.  The same shares offer tremendous potential risk if the company's intrinsic value is only $30.  To quote Warren Buffett:

"I put heavy weight on certainty . . . If you do that, the whole idea of a risk factor doesn't make any sense to me.  You don't [invest] where you take a significant risk.  But it's not risky to buy securities at a fraction of what they're worth."

Mathematical diversification should not be an end or the means.  To many, it has become an excuse, on that necessarily leads to mediocre stock picking.  One clear advantage to value investing is that investors need not hoard stocks like souvenir spoons or Beenie Babies.  A well-rounded portfolio of eight to a dozen companies, each bought at favorable prices, possessing solid fundamentals, and offering suitable upside potential, is sufficient for most investors to achieve their goals."

 

 

Very deep insight really.

In our good old school days we read sanskrit, history , geography, biology So many diversified subjects. In our colleges it was diversified and finally specialised. I think we can not really tell that school education was a sign of weakness. Later dates even in technical institution  we were taught diversified subjects. Once I enquired also with one of our professor forthe probable reason behind it. He mildly answered, the Syllabus are diversified for the students to acquire an inherent  patience and to encourage the habit of reading. It just help us to acuire knowledge that may not be the course for bread and butter. So truly I think the diversification is one route for specialisation.

All of us know that it started with  Fidelity approach in Indian equity fund with 75 stocks at there portfolio, since then there was a strong debate about its requirement and many people have different opinion on it. But Fidelity started with diversification and probably the did not disappoint us!

Yes when one company wish to diversify its business some people may find an wekness of its inherent business wheras some people cheers up and praises the management. Most BSE and NSE declaration of spreading business in diversified sectors by organisations are welcomed and the stocks move upwards.

If I recollect correctly long back in TED  once Reetsh discussed about stubborn and commitment in stock market behind the stocks. That was well said and well discussed.  I believe that through the process of diversification one can be highly specialised in his or her area provided he / she should have commitment and should not be stagnant in his or her journey. Incidentally I also worked with all those 121 stocks as discussed above and I can recollect reports / data (from analysts at different times) on those stcoks for a probable turning around stories as is happening in IFCI nowadays. Vipul please note that very few poeple can be as good analyser as you.