Finance theory tells us diversification reduces risk – we subscribe only partly to this theory. We believe in diversification across asset classes (eg. cash, property, stocks), but not within an asset class.
A prudent risk management approach can be implemented with a concentrated stock portfolio.
Diversify across different asset classes, but not within each asset class.
Imagine you’re given a $1m inheritance. But before you can spend it, the inheritance has a condition to it – in exactly 10 years to the day from now, the $1m must be worth at least $3m. You ponder this daunting task – the condition implies that in exactly 10 years, the portfolio must have generated an average return of 11.6% p.a over the next 10 years.
Ideally, there would be an investment that guaranteed you 11.6% over the next 10 years with no risk. We know there are no such investments. If we invested it all in cash, we know we would not achieve 11.6% growth. We could invest it all in property, but we would need to be certain that we’ve picked the right property and even then, 11.6% is a high hurdle.
Investing all of the money in stocks gives us the best chance of achieving this target – over the long term, stocks generate the highest returns of these 3 asset classes, given they are inherently more volatile. However before we invest it all in stocks, there is a possibility that there could be a stock market crash in exactly 10 years time that leads us to fail the condition on the last day. Given our preference for stocks, how can we best duly mitigate risk, whilst attaining our targeted 11.6% return?
We need to balance risk protection, without being so conservative that we are inhibited from generating adequate returns. From our experience, the answer to this question lies in a 2 tiered approach. First, we should spread our investments across cash, property and stocks. Diversification across these asset classes gives us an initial level of protection against potential crash in any one of these markets in 10 years time. In a stock market crash, all stocks crash. Not one sector or industry is immune. Therefore diversification through buying different stocks does not give us much comfort. However, it is less likely that interest rates, housing prices and stock prices all fall simultaneously together on the same day. Therefore, diversifying across asset classes (ie. cash, property, stocks) gives us much greater protection than diversifying in just one asset class (ie. buying many different stocks in the hope of immunising against a stock market crash).
Second, we should look to manage risk within each class. Once we are comfortable with our asset class allocation, we have minimised a large proportion of risk. The smaller portion of risk that remains is how each asset class performs. Conventional financial theorists will argue that diversification within each asset class provides further risk reduction. That is, for cash, we would buy several different bonds. For property, we would aim to buy different property in different suburbs. For stocks, we would buy stocks in different sectors and industries. From experience, we consider diversification to be one such technique when it comes to risk management within an asset class, but not the most effective.
Managing risk in a bespoke way
Diversification within an asset class, for example stocks, is a scatter-gun approach that poses too great an impost on returns. In our view, it is a crude way of approaching risk management that produces average returns.
In contrast, an investor should delve into the detail of each stock to analyse the risk of the underlying business. How prudent is the management team? Do they have a genuine interest to see the business succeed over the long term? Is the business operating in a viable industry? How much debt does the company have? Is the business profitable? These are the pertinent questions that ultimately manage risk, not a scatter-gun approach. Analysis and detail should be used to protect against loss, not broad sector generalisations. We much prefer to carefully select one solid basket to keep our eggs in rather than wantonly select a lot of different baskets in hope that on average they will be good enough. We only invest when we are confident in our understanding of the risks within each business. On the other hand, diversification implies a certain level of uncertainty and lack of conviction in one’s analysis.
Risk management is at the forefront of our investment approach. Thinking back to our example, imagine how hard it would be to generate the required return if we were to lose a significant portion of our capital at the start. Wealth can only be generated over the long term if we first protect ourselves against potential losses. In our search to mitigate risk, we often find that a pleasant benefit of our approach is that we discover great businesses along the way that produce outstanding returns over the long run.