U.S. Markets open in 6 hrs 17 mins

Strategic Value Investing: Diversification

In reviewing the investing styles of nine prominent value investing gurus, the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" made diversification one of their criteria. Some of the investors they researched, like Warren Buffett (Trades, Portfolio) and Bill Ruane, ran relatively concentrated portfolios, while Charles Brandes (Trades, Portfolio) and the leadership team at Tweedy Browne operated more diverse portfolios.


According to the authors, it does not take many stocks to be diversified. Stephen Horan, Robert R. Johnson and Thomas Robinson cited a study that found 10 stocks were enough to suitably diversify a portfolio. They also provided this chart that shows 90% of diversification's benefits can be realized with just 10 securities:

Strategic Value Investing GuruFocus Diversification

The authors added that "nearly full diversification" can be met with as few as 30 positions. But, a 10 to 20 stock portfolio can only be diversified if the stocks are spread across industries.

Of course, it is quite easy to over-diversify and end up with what they call "a menagerie" rather than a portfolio. Further, the more stocks you own, the more monitoring and analysis you must do, and apparently there is a consensus that anything more than 30 stocks is too much for one individual investor.

If you're buying that many stocks, you would likely be better off simply buying an index fund and settling for the market return (which likely would be higher than what you could earn on your own if you are trying to juggle too many stocks). The authors added, "You can still be a value investor using index funds or other pooled funds by choosing the right funds," which they promised to discuss in a forthcoming chapter.

The book noted that many, and perhaps most, investors have at one time or another asked themselves why they didn't just put all of their money into one or a few really good ideas. After all, if you had invested in Green Mountain Coffee Roasters (now Keurig Dr Pepper (NYSE:KDP)) you would have seen your investment grow by 9,210% (it later tanked). Also cited is Peter Lynch's famous observation from a couple of decades ago, "Who would have suspected that if you'd bought the Subaru stock along with the Subaru car, (in the early 1970s) you'd be a millionaire today."

Even the authors admitted they had missed wonderful opportunities because they didn't plunge heavily into certain stocks. One of them, Robert (Bob) Johnson, a professor of finance, worked with both Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) and Ameritrade (now TD Ameritrade (NASDAQ:AMTD)) and their principals, Buffett and Joe Ricketts, yet apparently did not invest in them.

On a related but different topic, companies like Berkshire Hathaway are already diversified. Under Buffett's direction, the company has bought big stakes in Coca-Cola (NYSE:KO), American Express (NYSE:AXP), Anheuser-Busch (ABI) and more. With everything from a candy company to a railroad and beer company, Berkshire Hathaway is well diversified.

On another related subject, the authors noted that many investors decide to concentrate in the stock of their employers. Sometimes this happens because of loyalty to the company, sometimes because the employer matches their purchases or for other reasons. Investing in just your employer's stock is obviously simple and easy, but as the employees of Enron learned, it can also be fatal to your retirement dreams. That stock went up more than 2,500% between 1985 and early 2001, but by the end of 2001 that value had completely vaporized.

We've also noted in passing that a portfolio needs stocks from a variety of industries to be diversified; 10 stocks in one industry is not diversification. The broader the diversification among industries and sectors, the better the protection. As the Enron story emphasized, an investor who runs a concentrated portfolio must be a master of timing.

Some pundits have boiled down the diversification issue to one question: "Do you want to sleep well or eat well?" A concentrated portfolio may make you more prosperous, and able to eat very well, but if you want to sleep at night, you're better off with diversification.

The authors concluded their section on diversification by suggesting that moderation is the key, adding that not even Buffett bets the farm on his single best idea. As for Horan, Johnson and Robinson, they all have diversified portfolios, and the degrees of diversification in them reflect their appetite for risk:


"Each of the three authors of this book holds a portfolio that is well diversified. We all are certainly comfortable with our degree of investment knowledge, having chosen to dedicate our careers to financial education. Yet we also realize that we are not willing to stake our standard of living on beliefs that can look valid before the fact, yet later could be proven invalid by factors beyond our control."



Conclusion

We began this section on diversification by asking whether we should follow the relatively concentrated portfolios of Buffett and Ruane or the more widely diversified portfolios of Brandes and Tweedy Browne.

The essential answer is that it depends on your tolerance for risk. More adventurous investors may opt for more concentration while cautious investors should opt for greater diversification.

But no matter where you land on the spectrum, some diversification should always be used, if for no other reason than protecting against those "factors beyond our control."

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

Strategic Value Investing: Tolerance for Risk

Strategic Value Investing: Regret Aversion

Strategic Value Investing: Patience Pays Off

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.