Even new entrants to the field of investing will be aware of the danger of ’putting all your eggs in one basket.’ This handy little metaphor serves to remind us of the wisdom of diversification, i.e. of owning a number of different shares rather than just one or two. This concept, now taken for granted, is known as ’Modern Portfolio Theory’ (MPT) and it revolutionised the thinking of investment professionals when it was first introduced.
MPT is based on the premise that all investors want two things: to avoid risk, and to earn a satisfactory return on their investments. Before the advent of MPT, it was generally accepted that higher levels of return could only be achieved if investors took on higher levels of risk. However, MPT showed investors how they could obtain the return they sought at the lowest level of risk possible.
MPT was the brainchild of Harry Markowitz, who in the 1950s showed that a portfolio of risky (i.e. volatile) shares could be combined in such a way, that the portfolio as a whole could be less risky than the individual shares making up the portfolio.
An example to help explain MPT
The concept can be illustrated by way of a simple example. Let us assume that an island has an economy with just two businesses; one is a tourist resort, the other an umbrella manufacturer. During sunny seasons the resort business does a booming trade, whereas the umbrella business struggles. In the rainy season, however, the umbrella business enjoys high sales while the tourist resort experiences a slump in business.
Let us assume that an investor living on the island wishes to make a return of 12.5% on his investments. Let us also assume that the resort makes returns of 50% when the weather is sunny, and returns of -25% when it rains. The umbrella business, on the other hand, makes returns of -25% in the sunny season and 50% in the rainy season.
An investor buying just one of these shares could have a bumpy ride, depending on how the weather turns out. Prolonged periods of sunshine would produce 50% returns, but lengthy periods of rain would see negative returns of -25%. If, in the long term, the weather was sunny for 50% of the time and wet for the rest of the time, the average return would be (50% x 50%) + (50% x -25%) = 25% - 12,5% = 12,5%. So in the long run the investor would obtain the required return, but could experience considerable volatility in returns in the short term.
However, if the investor were to invest half of his funds in resort shares and half in umbrella shares, he would always be earning 50% on half of the invested funds, and -25% on the other half, no matter what the weather might be. So the average return would be 12.5%, with zero volatility in returns.
Risk reduction and correlation between shares
This simple example illustrates the basic advantage of diversification. However, what makes this example work is the fact that, although both investments are risky (i.e. their returns could vary considerably from year to year), they are affected differently by weather conditions. This is the critical proviso of MPT: As long as the fortunes of the companies in a portfolio don’t move together in perfect harmony, diversification will always reduce risk.
The implication is that portfolio selection should take this fact into account. So, for example, an investor looking to compile a diversified portfolio that reduces risk, should ideally look for combinations of shares that perform differently at different stages of the economic cycle. Certain shares that perform well during boom times should therefore be offset by ’defensive’ shares (e.g. alcohol and tobacco shares) which achieve good returns during recessions, when the ’boom time’ shares are under-performing.
Although the above scenario is ideal, it is often not practical. What should be emphasised, therefore, is that ’negative correlation’ is not essential to achieve the risk reduction benefits from diversification. (Negative correlation means that, if one share increases in value the other will decrease in value, and vice versa, as per our resort and umbrella example).
Risk reduction can be achieved even if both shares are positively correlated, i.e. if they both increase and decrease in value at the same time, but by different percentages of their values. This was Markowitz’s great contribution to our understanding of risk reduction, by way of share portfolios made up of a variety of different shares.
How much diversification is necessary?
The next question that arises is the degree of diversification necessary, i.e, is there an optimum number of shares at which the diversification effect is maximised (and after which, the addition of additional shares to the portfolio won’t have any effect on risk reduction?). The answer is yes, but the number of shares to be held differs, depending on who you ask!
Based on the original research carried out by Markowitz, about 50 well-diversified shares will optimise risk reduction. In this instance, ’well-diversified’ means 50 equal-sized shares spread across all sectors of the stock market. However, in recent times other investment specialists have suggested that this figure is too high.
For example, Philip A. Fisher, author of the investment classic ’Common Stocks and Uncommon Profits,’ has this to say: ’Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know, and far too much in others about which they know nothing at all. It never seems to occur to them that buying a company without having sufficient knowledge of it, may be even more dangerous than having inadequate diversification.’
Warren Buffett is a firm believer in this philosophy. His investment company, Berkshire Hathaway, does not invest in a huge range of companies, but does invest huge amounts in a smaller number of businesses. Buffett endorses Fisher’s views, and has famously said that it is not a bad thing to put all your eggs in one basket, as long as you watch the basket closely.
Fisher is reluctant to specify the exact number of shares required in a balanced portfolio, but suggests three alternative portfolios. The first would comprise of a minimum of five large growth stocks (with no more than 20% of the original value of the portfolio being invested in any one company). He adds that there should also be a minimum amount of overlapping in the product lines of the various companies.
Fisher’s second alternative would consist of a portfolio of holdings in companies which fall midway in size between young growth companies with a high degree of risk, and the large growth companies described in his first portfolio. In this case a minimum of ten companies would be required, with a maximum of 10% of the initial investment being made in any one company.
The third possible portfolio suggested by Fisher would comprise of a selection of small companies with huge growth potential if successful, but which could fail spectacularly if unsuccessful. Fisher emphasises that you should never put any funds into this portfolio that you can’t afford to lose, and that you should limit your investment in any one company, to a maximum of 5% of the original portfolio value.
Fisher’s three possible portfolios increase in riskiness from numbers one to three, and the choice of portfolio would therefore depend on the degree to which individual investors are willing to accept risk. Fisher is an advocate of growth investing, as reflected by his portfolio choices, but investors should be aware that other alternatives exist.
For example, some writers suggest that different classes of assets can be combined in a diversified portfolio. Such a portfolio could include shares, bonds, and real-estate investment trusts (REITS). The performance of each of these is driven by different economic factors, thereby ensuring an effective degree of diversification.
It is clear that different approaches can be taken to obtain the benefits of a diversified portfolio. If you are fortunate enough to be able to build an investment portfolio, bear these in mind to ensure that you maximise returns at the lowest possible risk to your financial wellbeing.
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.