Diversification or Di"worse"ification ?

It's been quite some time since I mentioned the topic of diversification as compared to focused (value) investing. I've been reading news articls in the papers which mention the benefits of diversification, and the standard dogma for professionals in brokerage and investment banking firms is that diversification reduces your risk and helps to achieve an average return on your investments.

True, I have to agree with the pundits that being diversified does help to mitigate risks which may be company-specific or industry-specific. But in any case, an investor has to do appropriate and detailed research first in order to sniff out potential trouble before investing. Cases like Malaysia's Transmile scandal and Singapore's China Aviation Oil are striking examples of frauds in large, established companies with big names involved (Robert Kuok in the former and Temasek for the latter). These examples seek to highlight the fact that one should not dump everything into one company as it may be extremely risky to do so.

Coming from another angle though, is Mr. Warren Buffett and Mr. Peter Lynch. Mr. Lynch is the famed investor for the Fidelity Fund, which has achieved consistently good returns over a period of 20+ years. He described diversification as "diworsification" in that you start getting your fingers into too many pies; thus one cannot discern the true taste of each individual pie. Diversification also tends to lower your total portofolio returns as a 100% gain in one company spread over 10 stocks only increases your portfolio gain by 10%. Mr. Buffett mentions that diversification is for people who do not know what they are doing, and it is a perfectly sound strategy for people who do not know how to value companies.

For those who take the time, effort and patience to analyze individual businesses, they will realize that focused investing can reap huge rewards. As Mr. Buffett says, it is better to have a lot of a few (companies), rather than a few of a lot. Most people's portfolio (as posted in forums) consist of at least 15-20 companies. How in the world is one going to track the progress, financials and growth of each company when one has 15-20 to contend with ? To be frank, I have problems keeping up with the dynamics of my 5 companies (REIT not included), let alone 10 or more. Of course, in this case we are referring to companies which are reasonably active in growing their businesses, and not "dormant" companies whose Management hardly tries to achieve consistent growth over the years. Owning a lot of a few means buying large quantities of shares in a company in which one has researched thoroughly and which offers a decent margin of safety.

Diversifcation is for those who do not wish to "sweat" too much in their search for hidden gems (i.e. undervalued companies with good cash management and strong earnings prospects). It will enable you to achieve average returns because that's what mutual funds (unit trusts) are doing as well. The joke is that most mutual funds (up to 90% at one point in time) either under-perform the market or just manage to perform on par with market indices. One must take into account the fact that not only are funds well-diversified (in fact, some are OVER-diversified), but the constant buying/selling activity also creates frictional costs which erode value for the unit trust holder. Add Management and Performance fees in and you can see why I acoid unit trusts !

That said, Mr. Buffett does recommend index-linked funds for those who wish to achieve a market level of return (the "lazy investor"). These are funds which are tied to a particular stock index (e.g. Straits Times Index or S&P 500) and ETFs (Exchange-Traded Funds) are one type of index fund. Unfortunately, ETFs are still not widely accepted in Singapore and are relatively illiquid and under-appreciated. Most of the talk now is on risky warrants (more on this in future posts) and quick money; but most people fail to appreciate the fact that sometimes, "slow" money can be better in the long run than the promise of quick money as "slow" money can compound over time. I will blog more on ETFs if I get the chance to research more into it.

What I do personally believe in however, is to diversify across different investment classes. For example, I do have money parked in equities as well as an insurance savings plan. Equities are natually viewed as volatile and are subject to up and down swings of market sentiment, plus I take a long-term approach; thus they are not suitable for liquidation at short notice. A regular savings plan guarantees me a 3.5% interest rate per annum (compounded if I leave the money inside) as well as dividends on my savings after the 3rd year. In addition, I also keep sufficient cash in my bank to tide over emergencies and to ensure I have funds for buying shares cheaply should a market crash occur. This covers the aspect of money management which I will also attempt to dedicate a post to in the near future.