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The Case Against Diversification

Over-diversification can do you more harm than good, stick to your core competence instead…

What is the first piece of investment wisdom that self-appointed experts teach you? Hold many eggs in many baskets, because you don’t know which egg (or which basket) is bad. The argument for making a portfolio out of everything is repeated so often that its echo is often confused as the prevailing wisdom. Yet, when we talk about real businesses, we make the exact opposite argument, i.e., focus on your core competence. The underlying assumption is that for a business to be competitive, it must have scale; intelligence, knowledge and data (about costs and revenues); and enough perspective, wisdom, philosophy and know-why in all its business processes to ensure that it outperforms competition.

Few activities require as much perspective as investing. If markets are a mechanism for the transfer of wealth from the foolish (many) to the intelligent (few), then the meaning of these words has to be spelt out carefully. Investing is at least as much about having intelligence as it is about having money (to invest) in the first place. Thereafter, the principle of compounding tells us that intelligence or perspective plays a disproportionate role in deciding who wins the investment sweepstakes.

Warren Buffet tells you to buy a part of the business, and thereafter, to own your shares like you own a business. He dwells on these aspects at length, and then goes on to tell you that “the best time to sell a good investment is never”. Indirectly, he too is harping on the principle of core competence.

Do not diversify blindly
Blind diversification for its own sake is just that —blind. If you don’t know what you are doing, you are more likely to step into a puddle if you walk on many roads. As any blind person will tell you, the best way to ‘see’ where you are going is to get a sense of a place by doing repeated passes down the same road.
Jobbers often look like day traders, and have been unfairly given a bad name, both the categories being tarred with the same brush. Some of the best jobbers, however, stick to the same stock for a lifetime, actually adhering to Warren Buffet’s advice of never leaving a stock, even as they buy and sell the stock many times during a day. Not only do they add liquidity to the stock, they have local insights about the price discovery prevailing in a stock, its different moods, and its penchant for surprise that outsiders will never have. This is perspective, something the stereotypical day trader does not have.

Frame a hypothesis
Investors get paid to identify trends; they make money when they correctly anticipate a trend. Markets are a discounting mechanism. The winners are those who forecast accurately, and then put their money behind a hypothesis. If any of these three is missing (i.e., the forecast, the money or the hypothesis), you don’t make money. The hangers-on, i.e., the pundits, sit on the sidelines and pass comment on the players. They are about as right as any cricket fan about whether Sachin will carry India to victory. And their winning odds are similar.
So diversify, they say, but against what? If you don’t articulate the risks you face, what will you diversify against? The gullible investor actually buys hope, and as we all know, “hope is not a strategy”. The cost of buying hope is actually the cost of buying randomness, and variability and unpredictability in investment returns. Most importantly, if you don’t know what you did right, you have no hope of ever being able to repeat your success.
The pundits will tell you that your winners will make up for your losers, and that is the purpose of diversification. But if you don’t know (and don’t learn) how to tell one from the other, you have to live with the general belief that most stocks go up in the long run. This is often referred to as market returns. This, as we know, from recent experience, is not true over long stretches of time, and (as you know from personal experience) is not the experience of most retail investors. However, this opinion (that markets go up in the long run) is prone to take widespread root in a late bull market, and shortly thereafter, is seen to be in the breach. Ironically, poor timing kills the people who claim to ignore market timing.
Over the last five months, you could have bought low-beta stocks (like Bharti, Power Grid Corporation), sold high-beta stocks (like real estate and banks), bought the dollar (against the rupee), sold the Euro (against the rupee), and bought silver and sold gold. Most of these positions would have worked out. To the uninitiated, this would look like diversification, but it is actually the same investment hypothesis, the same forecast. It may have been articulated over different instruments, but the underlying economic logic is unified. Similarly, in 2007-08, you could have bought a low-beta stock like Hero Honda, sold a high-beta stock like DLF, bought the dollar (against the rupee), sold the dollar (against the Japanese yen), bought gold and sold the broad market. If you diversify blindly, you might get some legs right by accident, but you would be most likely to get enough legs wrong to ensure that you destroy value.
If you have the right economic arguments, you may choose to articulate it with one instrument or 10. That in itself is irrelevant. If your method of building your investment hypothesis is flawed, you have no hope — rather like the novice skydiver who took along three parachutes instead of one, but forgot to learn how to open them. Without the underlying knowledge, diversification is bound to lead to disaster. How about telling the novice to eschew skydiving till he learns enough about it? Novices should not be investing; they should be saving, generating capital, and if they must diversify, they can always buy two-year bank fixed deposits along with one-year bank fixed deposits.
If you do not know how to articulate an investment hypothesis, diversification is actually “di-worse-ification”, i.e., it means that you are investing in the probability that you are wrong. The way to manage that is through hard work and greater diligence, not through diversification. If it turns out that you did a good job, you will actually reduce your investment returns, not your risk.
It is when you don’t know which way the trend is going (i.e., you don’t know investing), you say that through diversification: I don’t know, and I am just hoping.

How good is a buy-and-hold strategy?
Which brings me to the idea of ‘buy and hold’, another canard floating around in the investment markets. When we buy a stock, we are actually buying a business, whose returns over the long-term are linked to the fortunes of the business. Now, business risk is complex, has many aspects, and there are many of them. Even the people running the business don’t have a full grip on all the risks in that business, and cannot tell you, for example, how much they will make (and why) in, say, five years. Why then, would buy-and-hold be such a good idea? Just because you don’t know any better, and the pundits you trust don’t know either?
How about trying to figure out the volatility (of price discovery) in a stock? It is difficult and complex, perhaps, but it saves you the effort of trying to understand the long-term prospects of the sector. For example, it is much easier to buy a telecom stock when everybody is decided that “telecom is an underperformer”, and then try to figure out the patterns in the stock, i.e., buy the stock when the rollover cost is negative and sell it when the rollover cost crosses 1 per cent per month. Try figuring out the rest of the business: which way will 3G go, what effect will cloud computing have on telecom, which African country is going up in flames, who is the new telecom minister, what new social network is emerging among kids (and is it a threat to, or an opportunity for, telecom), and which new industry is going to come out of nowhere to suddenly replace the existing technologies in telecom?

Market timing is important
To those who say, ‘just buy a mediocre management in a great business, rather than good management in bad business’, make sure that you define ‘good business’ well. Is soft drinks a great business, and is Coke a great company? And if it is (a great company), is it also a great stock? Depends on when you catch it. Market timers might choose to look for an irrational seller, who gives away great value because of a weaker moment. Those who choose to ignore timing are saying that the company’s business performance will be adequate to create value, i.e., the greatness of the business is a replacement for the lack of skill on the part of the investor. Because the company works hard, you (the investor) don’t have to!