The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

23 February 2007

On risk and diversification

I received an interesting email message yesterday. It regards my thoughts re hedging. The writer, who prefers to remain anonymous, shares several important and profound insights. It so happens the writer's notion of "farm team" investing is precisely my methodology.

What can I say but that I wish I had written the letter. Oh well, it remains well worth your time to read -- whether you are an investor or a student of the markets.
-- David M Gordon / The Deipnosophist

Hi, David,

Read and enjoyed your comments on risk and diversification.

I think nine to be a perfectly good number, and I agree that it reduces stock-specific risk to a significant enough degree that it is a reasonable way to go for many investors. Certainly some great investors have achieved tremendous returns through this level of concentration. On the other hand -- and ignoring hedging entirely -- I think it's awfully important to look at risk control (and risk-reward maximization) from a number of angles beyond the number of stocks that one holds in a portfolio. First, and most importantly, there's the issue of diversification, or lack thereof, amongst sectors. A portfolio of nine biotech's is a very risky portfolio, although it might also be a very rewarding portfolio if one holds it during a bull phase in biotech. As to the proposition that thirty or more stocks in a portfolio essentially equals investing in an index, that is demonstrably not true for a significant number of great managers. The legendary Peter Lynch crushed the averages over a very long period of time with portfolios of many hundreds of stocks. I could add the names of many other great investors who have also done so -- over very long periods -- because their portfolios (exceeding 30 stocks) are concentrated in the right places at the right times -- as to industry, value, growth, big cap, small cap, etc.

There's also much to be said for the "farm team" approach to portfolio construction -- a strategy that many great investors employ -- where roughly half of the value of a portfolio will be concentrated in their best ideas (perhaps ten stocks), with another twenty or thirty names comprising much smaller positions on the "farm team." The advantage of this approach is that it puts some skin in the game on the smaller positions, which always has the effect of bringing a higher level of awareness to those positions than is ever achieved by simply putting them on a watch list. There's nothing like money at stake to concentrate the mind on your "watch list," thus enabling one to elevate a particularly promising minor leaguer to the majors at a propitious time.

The whole question of striving to achieve the best possible risk-reward ratio for a portfolio is obviously one of great complexity -- hence the volumes of studies on the subject. But at the end of the day -- at least as to the question of reducing risk -- I would echo the master, Warren Buffett, when he counsels that "risk is not knowing what you own.


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