Should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is a good one at one end is the advice that you get from the efficient markets camp: maximum diversification across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” held in proportion to its market value. At the other is the “all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.
Which Gospel? Mark or John
These arguments got media attention recently, because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated at $2.5 billion), as an entrepreneur. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the founder of Vanguard, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about."
So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: First, how certain your assessment of value and second, how certain you are about the market price adjusting to that value within your specified time horizon.
At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:
1. Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage and it is feasible only with finite lived assets (such as options, futures and fixed income securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
2. A perfect tip: On a more cynical note, you can make guaranteed profits if you are the recipient of inside information about an upcoming news releases, but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. The problem, of course, is that you would be guilty of insider trading and may end up in jail.
At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market hypothesis), you should be as diversified as you can get.
Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over pced for a long time.
How Diversified?
Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:
A. Uncertainty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, as a general rule, your response to more uncertainty should be more diversification.
B. Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversified in your holdings.
In summary, then, there is nothing crazy about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value.
Bottom Line
Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assessment skills, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much.
CBlakely CFP®, CTFA 02/2012
Source: New York University Stern/Damodaran
Which Gospel? Mark or John
These arguments got media attention recently, because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated at $2.5 billion), as an entrepreneur. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the founder of Vanguard, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about."
So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: First, how certain your assessment of value and second, how certain you are about the market price adjusting to that value within your specified time horizon.
At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:
1. Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage and it is feasible only with finite lived assets (such as options, futures and fixed income securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.
2. A perfect tip: On a more cynical note, you can make guaranteed profits if you are the recipient of inside information about an upcoming news releases, but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. The problem, of course, is that you would be guilty of insider trading and may end up in jail.
At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market hypothesis), you should be as diversified as you can get.
Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over pced for a long time.
How Diversified?
Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:
A. Uncertainty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, as a general rule, your response to more uncertainty should be more diversification.
B. Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversified in your holdings.
In summary, then, there is nothing crazy about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value.
Bottom Line
Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assessment skills, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much.
CBlakely CFP®, CTFA 02/2012
Source: New York University Stern/Damodaran
