Digging Into Stock Diversification

By Heide B. Malhotra, Epoch Times
April 24, 2013 12:30 am Last Updated: April 24, 2013 12:30 am

Stock diversification is recommended by some stock market analysts, while others caution against such actions unless one is knowledgeable in stock market movements and understands the valuation of a company’s financial wherewithal.

There are those who suggest that diversification of a stock portfolio lessens the risk of losing too much money when one stock falls below a comfortable level, as the risk is allocated among a number of different stocks with some increasing and others decreasing in value.

Smart diversification means that investors don’t buy stock in the same industry, of the same type, or in companies located in the same geographical area, but should invest in stocks that have no relationship to each other.

For example, an investor buys into several mutual funds, which are funds that hold securities, including stocks or bonds, and are administered by a money manager, without scrutinizing the stocks held in the fund. It could be that every single fund holds the same stocks and thus if any of the stocks suffers a decline, all funds will be affected.

It is not wise to keep a stock that does well in the short-term because one can make a quick buck. Such an approach is considered gaming the market and speculative in nature. Speculation has been the downfall for many investors, especially when the market is in a volatile stage.

Also, diversification into too many different industry sectors could result in losing oversight over the stock portfolio.

By carefully choosing different stock types, investors may be able to minimize loss. For example, when one stock experiences a drop, another stock may increase by the amount lost.

To achieve the least risk, although risk is not completely eliminated in holding stocks of any kind, “an investor chooses a mix of investment types that will experience fluctuations in the financial markets at different rates and times,” according to a Feb. 20 article on the Money Reasons website.

Warren Buffett Truths

“In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies,” a Jan. 21 article on Julian Livy’s Warren Buffett Secrets website states.

According to an April 18 article on the StreetAuthority website, Berkshire Hathaway Inc. has stocks in 42 publicly traded companies, with the top five comprising 73 percent of the entire Berkshire portfolio.

For a company the size of Berkshire—with total shareholder equity of $427 billion, total revenues of $163 billion, and $15 billion in profits as of Dec. 31, 2012, according to the company’s annual report—42 stocks are very few.

Analyzing Buffett’s Strategy

“Even the astute manager knows that most individuals could not accept the risks of Warren Buffet’s [sic] approach,” according to a report about the Buffett diversification approach on the TAMRIS Consultancy Money Managed Properly website.

The report suggests that Buffett’s approach is an exception and should not be copied by individual investors or by investment companies.

Investors should look at their strengths and weaknesses, evaluate the stock market carefully, and deal with risk and expected return based on comfort level. Investors should not copy Buffett’s investment style because he is successful, but because of a true understanding of the reasoning behind Buffett’s investment strategy.

“Buffett really views diversification as a return management platform, not a risk management platform. … His stock selection discipline is based on a combination of stock valuation and assessment of fundamental business structure and rationale,” the TAMRIS report suggests.

Keys for Successful Investing

Investment firms recommend that when diversifying, the investor should find the right balance between consistent returns and risk taking, because it makes the portfolio less dependent on the individual stock or bond.

To shield a portfolio against volatility, one should invest in a number of different business sectors, such as the agricultural, manufacturing, financial, transportation, and communication sectors.

For investors who are not fully risk adverse and fall in the medium risk category (that is, they are willing to take a higher risk for greater earnings), a Feb. 10 article on the Seeking Alpha website suggests a diversification portfolio that includes secular, cyclical, and speculative/growth investments.

Secular investments are stocks of companies that continue to grow and perform satisfactorily despite economic downturns. The article suggests that McDonald’s Corp. and Philip Morris International Inc. are considered secular investment companies.

Companies that do well during good economic times are considered cyclical investments. Companies in that group include banks such as JPMorgan Chase & Co., hard drive maker Seagate Technology PLC, and car maker Ford Motor Co.

The speculative category includes stocks that have growth potential, such as XPO Logistics Inc., Spectrum Pharmaceuticals Inc., and Alcatel-Lucent.

The author of the article calls his strategy a “new age method” and states: “I simply invested in companies to serve an actual purpose in my portfolio rather than buying an index fund, a bond, or a mutual fund. … I am greatly diversified and am well-positioned with undervalued companies that have growth and have allocated capital based on my risk assessment.”

Diversification of one’s portfolio is a risk technique where investors do not put all their eggs into one basket as protection against a downturn in the economic fortunes of an industrial sector. The Internet discusses different options, but always cautions that no strategy is foolproof.