Diversification is quite simply the spreading of one’s investment across a range of assets, the goal being to reduce investment risk. Contrary to popular belief, diversification is a balancing act rather than a free lunch.
To understand our approach to diversification, one first has to understand what drives investment return:
The goal of investment is to earn a good return. Return = Yield + Capital Appreciation (what you receive in dividends plus the change in share price). Capital Appreciation = Growth + Revaluation, i.e. the fundamental growth of the business (measured in terms of revenue, profit, book value, etc.) and the change in the share price relative to the fundamental value of the business. Therefor Return = Yield + Growth + Revaluation. This is a mathematical identity that always has to be true. Yield and Growth are driven by business fundamentals – a good business can pay dividends and grow its revenues and profits year after year. This is a sustainable source of return, and is driven by business quality: Quality -> Sustainable Return = Yield + Growth. Revaluation on the other hand is driven by investor sentiment. As investor sentiment swings between optimism and pessimism, so the share price of a company relative to its fundamental value also swings. While investor sentiment tends to cancel itself out over very long periods of time, it is still a very significant driver of return over 5 – 10 year periods.
In a nutshell, the causality of return is business quality and price paid. To earn a good return over the long-term, we must invest in high quality businesses at attractive prices – nothing less, and nothing more.
So where does diversification come into this?
Unfortunately even the best quality businesses can fail (though they are far less likely to do so than inferior businesses) because of unpredictable events beyond their control: Natural disaster, fraud, expropriation, war, economic depression, etc. Alternatively, a once great business can deteriorate if it fails to remain competitive and adapt over time.
Fortunately, as often as things can go wrong, or businesses can disappoint, so too things can go right and businesses can exceed expectations. A company can be the subject of a buyout at a large premium, or can have a run of success beyond all expectations.
In contrast with the predictable direct causality that Quality and Price have on return, these positive and negative surprises are highly unpredictable. This means that in a completely undiversified portfolio, success or failure may have more to do with luck and randomness than quality or price. In a diversified portfolio, these surprises are more likely to cancel out to a degree, meaning that the outcome is more likely to be a result of quality and price – the things that a good investment process should focus on.
Rather than allowing luck to have an undue influence on our portfolios, we prefer to minimize the role of randomness and maximize the role of our investment process over time through a reasonable degree of diversification. The goal is to diversify away as many sources of randomness as possible (i.e. geography, industry, company, currency, etc.) without diversifying away the causality of superior long-term return (i.e. high quality at an attractive price). The second part of that last sentence is critically important and often forgotten. The best portfolio is probably one where the only common thread is quality and price. When this balance is not possible, it usually isn’t worth pursuing diversification at the expense of expected return.
All too often investors diversify so extensively, without any consideration for quality or price, that the long-term expected return of a portfolio declines rapidly as the two fundamental causes of superior return are diversified away completely. Sadly, this is the approach taken by many investment advisors: They neglect the fundamental causes of superior return by spreading their clients’ investments across a wide range of costly strategies in the pursuit of diversification, only to end up with an expensive index tracker. This is certainly not our approach.
It is worth noting that insofar as achieving healthy diversification whilst maintaining expected return is concerned, it is better to have a broad investment universe rather than a narrow one. While 25 – 40 stocks might sound like a lot, a portfolio of 40 stocks from an investment universe of 5 000 + stocks listed across the globe is likely to be far superior (better diversified, with a higher expected return) when compared to a more concentrated portfolio selected from a narrower universe of stocks. This is why we take a global view: We can achieve wide diversification, but still only invest in the top 1% of companies ranked by quality and price.