According to modern investment theory, diversification is a central feature to proper investment strategy. The theory holds that it is possible to diversify away the risks of holding securities by spreading this risk among many uncorrelated holdings. It’s a theory that has been widely followed, but one that has been tested by the recent financial meltdown in which stocks, bonds, commodities and real estate have all dropped in unison.
For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, “risk” is theoretically the standard deviation from the average return. Hence, diversification is not necessarily a way to reduce risk, but rather to lower volatility. We explore the flaws in this theory through two thought experiments.
Our first thought experiment consists of two investors with widely different portfolios. Investor A is aware of modern investment theory and is sure he can lower his investment risk by holding 3 uncorrelated investments: a real estate property, a stock, and a bond certificate. On the other side, investor B has decided to invest only in 3 real estate properties. Which investor has the riskier portfolio?
According to modern investment theory, investor A is more diversified, and therefore holds the less risky portfolio because his deviation from average return would ultimately be lower than the more correlated portfolio of investor B. This may be true, but let’s now imagine the portfolios look as follows:
Investor A
1. A stock whose company has no competitive advantage
2. A real estate property currently under water
3. Bonds of a company which cannot meet its future obligations
Investor B
1. Three real estate properties below fair value
Now that the content of each portfolio is known, I would argue, as most sane investors would, that the probability of permanent loss are higher in investor A’s portfolio. Thus, investor B’s portfolio is less risky.
This is the obvious flaw that haunts the diversification strategy most funds employ today, where holding hundreds (and sometimes thousands) of positions is considered less risky than concentration regardless of the fundamentals of each individual investment.
Unfortunately, these misguided definitions of diversification and risk are also employed in hedging strategies. For example, funds employing the so called “market-neutral” strategy aim to decrease risk by maintaining a balance between long and short positions. Though these funds may be better immunized from wild market volatility, this does not mean that the probability of capital loss is lower than any other strategies. In fact, the “a market neutral” strategy is used not to decrease investment risk, but rather to minimize redemptions, since investors are more likely to pull their money out of these funds when volatility is greater.
This takes us to our second thought experiment. Consider a portfolio that holds two stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. But the payoff in either case will always be 50% lower than the return we would realize on rainy days by concentrating on stocks that pay off only when it rains, and so on for shiny days. This thought experiment indicates that volatility is reduced, but above-average returns are more difficult to obtain. Many investors fall into this trap.
Since value investors tend to reject modern investment theory, it is not surprising that many also refuse to diversify. So how should value investors manage risk?
1. Forget about volatility
Volatility is not risk. In fact, volatility is what allows value investors to purchase companies at bargain prices. Unless you are a hedge fund trying to keep investors by making the market rides easier on their stomachs, volatility is not where your focus should be.
2. Don’t swing at every pitch
The standard response of value investors regarding diversification has been best expressed by Warren Buffett in his frequently cited baseball analogy. Buffett argues that great hitters such as Ted Williams were able to achieve high batting averages because they swung only to the pitches they were sure they could hit. Ted Williams stated:
My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were. The box shows my particular preferences, from what I considered my “happy zone” – where I could hit .400 or better – to the low outside corner – where the most I could hope to bat was .230. Only when the situation demands it should a hitter go for the low-percentage pitch.
Similarly, investors are more likely to invest successfully only in situations where the probability of return is high. This may mean investing only within a circle of competence (investing in understandable companies), staying on the sidelines during bullish times, and purchasing heavily during periods of uncertainty.
Those who invest in hundreds of opportunities at a time, as most funds do, are bound to be obtain returns almost identical to the general market. In this case, investors may be better served by simply buying the S&P500 index.
3. Place bets according to odds
It has been mathematically proven that the best gamblers are those who bet heavily when the odds are in their favor, and who stay on the sidelines when the odds are against them. Similarly, value investors tend to bet according to the likelihood of a positive outcome. In probability theory, the Kelly criterion is used to obtain the optimize size of a series of bets. In the simplest cases, it can be shown that the size of each bet or investment is proportional to the difference between the probability of winning and that of losing. For example, if an investment has a 60% chance of success – or 40% chance of failure – the size of the optimum bet should be 60%-40%, or 20% of the total portfolio.
4. Remain pessimistic: challenge own judgement
So how do value investors evaluate the probability of success for their investments? They tend to do so by continually focusing on what can go wrong with an investment rather than what can go right. Focusing on the negative prospects of each investment serves as a check in situations where the prevailing market sentiment is irrational (tech bubble, credit bubble, etc.)
