Diversification
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Article
The topic that brings us here today receives a lot of attention in the investment community, and for a good reason. Diversification as a concept is highly determinant of a portfolio’s future returns. I have briefly covered what it is in the past, but its relevance made me want to expand a bit. Moreover, opinions always change as information gets digested and, after reading things like Buffett and Terry Smith’s letters this past month, my perception may have changed. In this article, I’ll try to provide you with pieces of information to improve (if possible) your approach towards it. Diversification has a quite literal definition.
“Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio” Investopedia
Interpretation
Interpretation of this concept varies from person to person, as each of us have our own lenses to absorb information. On this occasion, I’ll try to go through my thoughts on the subject.
What I would first think when reading this is what does it mean with a ‘wide variety of investments.’ This could go from a variety of asset types like stocks, bonds, commodities, currencies, etc, to simply different types of investments like different companies within equity investing. Secondly, I’d emphasize the phrase ‘risk management strategy’ because, in here, an assumption seems to be made. What this implies is that one of the things an investor can do to address the inherent risk of investing is to thoroughly assess diversification. Lastly, the mention of it being within a same portfolio is crucial, for it determines the world in which diversification must be measured.
Measurement
Now that we’ve established the ground over which we’ll be playing, the actual objective that matters. Diversification by itself is futile. What an investor should try to determine (I think) is which is the level of diversification that not only they are willing to accept, but the one that they emotionally require and will, at the same time, maximize return while minimizing risk. As usual, that’s the objective, to maximize upside while minimizing downside, but considering one’s particular situation. I’ll provide you here with some of my thoughts on how one could measure diversification.
First point. In the world of equity, diversification is generally considered based on what are the main products of the different companies a portfolio owns, which is an incorrect premise. For instance, Amazon is often considered as an online retailer or a consumer discretionary company because of how it started. However, companies expand their offerings not only vertically, but horizontally as well. Now Amazon has Amazon Web Services, which is a business unit with an 80bn annual run rate. Perhaps nowadays Amazon is somewhat viewed as a cloud company, but it’s a very recent change in the general public’s appraisal.
Second point. A problem of past companies was that they were generally very attached to their region’s economy because that was their reach. For the past 30 years or so, the internet and technology innovations have allowed companies to sell products and services all across the globe and, when speaking of cloud-based products, with instant delivery. Consequently, many companies can now have presence in tens of different countries, making them more resilient to particular economies’ downturns. Their earnings exposure is geographically much wider than before.
Third point. It is also a good practice to consider a business’ clients because it is them who pay the bills and this can be viewed from two perspectives. Firstly, if there’s a company that sells only one product and that product is meant for physicians, then that company will be extremely susceptible to the physicians’ income market. Secondly, a company’s fragility depends on how many clients does it have. A company that derives 70% of revenue from one client is much more fragile than a company with no revenue concentration because it depends on this client’s circumstances, which they do not control.
Thinking Experiment
Nowadays, with only 3 companies, one could be getting more diversification than with 50 before. I’ll leave you with a question here:
Microsoft offers software products in almost all verticals, has an absurd number of clients, offers over 200 products within cloud computing, sells to companies in every single industry, earns revenue from many different segments and derives 50% of its revenue from the US and the rest worldwide.
Texas Instruments manufactures and sells chips in two main areas, embedded and analog semiconductors. It has more than 80 thousand products and more than 100 thousand clients with the largest one being less than 10%. TI sells to 6 different end markets that correspond to over 35 sectors. Lastly, it derives 33% of revenue from the US, 24% from China, 10% from the rest of Asia, 24% from Europe, Africa and the Middle East; 8% from Japan, and 1% from the rest of the world.
(I should update the pictures now haha)
Visa owns the largest payment processing network. It processes over 14tn in total payment volume and 244bn transactions annually. Visa has presence in over 200 countries, with over 3bn of Visa cards issued, 80 million merchants utilize the network and they are partnered with 16k financial institutions.
With only these three in a single portfolio, most parameters under which diversification could be evaluated seem to be fulfilled. Therefore, under the assumption of average management execution:
Two interesting quotes on the subject:
“Since we do not know the future, we cannot put all of our eggs in one basket”
“The addition of 100 stocks simply can’t reduce the potential variance in a portfolio performance sufficiently to compensate the negative effects.”
Personal Commentary
Remember the purpose of this newsletter is to help you think for yourself and make better investment decisions. There are many things to address regarding this topic, reason for which I’ll be coming back to it in the future. I hope you enjoyed the article!