At Baskin Wealth Management, our main mandate is to protect our client’s money.One way we try to do this is through diversification, which is simply spreading client funds over a variety of different investments. We diversify portfolios in three perspectives:
1. From an asset class perspective: having stocks, bonds, and preferred stocks.
2. From a geographic perspective: owning both Canadian and non-Canadian equities
3. From a sector perspective: owning stocks of companies in a wide variety of sectors and industries such as finance, technology, industrial, healthcare and real estate.
Some investors believe that diversification is a bad thing, arguing that it’s better to put all available capital into the best ideas, as opposed to putting money into, for example, the 20th or 21st best idea. They argue further that diversification reduces the amount that an investor can know about each individual holding.
From our perspective, the issue is not whether diversification is good but rather about how much a portfolio should diversify. We have no doubt that spreading risk across several investments is superior to having too many eggs in one basket. Recently, a high-profile medical startup company had a spectacular failure, when the main product turned out not to work. The high profile founder’s net worth of $1 billion vanished nearly overnight. While this is an extreme case, the lesson is clear.
For our clients, we feel that an ideal amount of diversification is around 20-30 equity holdings, with more stocks held in larger accounts. This is not to say that it is the “right” amount for everyone, but is a comfortable level that allows us to use our stock picking abilities while reducing the risk of any single company crashing a portfolio. In Joel Greenblatt’s book You Can Be A Stock Market Genius (one of our favorite books), Greenblatt demonstrates that owning 16 stocks eliminates 93% of the risk of just owning one stock, while owning 32 stocks eliminates 96%.
Simply diversifying is not enough. How a portfolio is diversified also matters. Purchasing the shares of two oil companies provides some diversification, but would not help very much when oil prices are falling. Furthermore, it is important to look inside each company to see the true risk exposures. For example, Hardwoods Distribution Inc. is a company that is listed on the TSX that most data sources would identify as Canadian. However, 80% of Hardwoods Distribution’s revenue is earned in the United States, and the single largest driver of Hardwoods is U.S. housing. It would be a mistake for a U.S. investor to buy Hardwoods and think that their U.S. exposure is being diversified.
A last, more subtle factor is that diversification is a way for us to recognize that our knowledge and abilities have limitations. In investing, one can do everything right and still lose money because of bad luck and unforeseen events. Diversifying forces us to admit that we cannot know everything about a company and that bad things can happen. It also makes us less emotionally invested in any particular holding, and allows us to sell when the situation changes. As a case study, a prominent hedge fund manager last year placed 25% of his fund into a pharmaceutical company and widely announced his position in conferences and on TV. When the stock fell by 80%, the hedge fund manager had become so emotionally and reputationally invested in the stock that he was unable to sell, and continued to add money into it as it fell. To date, billions have been lost.
Our approach to diversification does not prevent us from putting more money into our favorite ideas. However, it does lead to more stable returns in both good and bad times, something every long term investor values.
July 21, 2016