Thought for the Week (252):
Diversification – More than Meets the Eye
Synopsis

Diversification is the “Golden Rule” of investing, and proper implementation is absolutely
mandatory in a well-constructed portfolio.

Despite popular belief, diversification is not achieved by simply buying several high quality assets
in a portfolio because many securities react similarly to economic and market factors.

A well-diversified portfolio requires deep understanding of the drivers of the performance of
securities to avoid gaining too much exposure to one factor.

Portfolios should maintain a mix of geographic, asset class, sector, and style diversification.
Quantifying Diversification
Diversification is the “Golden Rule” of investing, and most long term investors will tell you that without
diversification, an investor is playing with fire. However, there’s much more to the concept of
diversification than meets the eye.
Before we talk about why proper diversification requires some thought, let’s first try to quantify the benefit.
The chart below shows the relationship between the number of securities in a portfolio (horizontal axis)
and the overall risk of the portfolio (vertical axis – “variance” is a fancy word for a measure of risk).
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahho! Finance.
This chart leaves us with two very important considerations:
1. Diversification is Critical: As the number of securities increases, the overall risk decreases
dramatically. If an investor owns 5 stocks and one is in a company that commits fraud, then 20%
of the portfolio is exposed to this risk. By owning 50 stocks, only 2% of the portfolio is at risk.
2. Law of Diminishing Returns: After approximately 50 securities in a portfolio, the benefits of
diversification end. This implication is critical for an investor because analyzing 50 companies is
substantially more manageable than analyzing 300 companies, particularly if the investor will gain
next to nothing by putting the work into analyzing the additional 250 stocks.
A natural conclusion from this chart would be to assume that a portfolio is well diversified once 50
securities are selected and included in the portfolio.
Based on this assumption alone, if an investor was seeking income generation through dividends and
interest, a portfolio of defensive stocks from sectors like telecom and utilities mixed with higher yielding
corporate bonds would not only meet the requirement of generating income but also appear to be well
diversified. However, nothing could be further from the truth.
The Devil is in the Details
Notice the pattern in the stock performance between Home Depot (green line) and Lowe’s (blue line)
from late 2008 until early 2012 in the chart below. These two stocks often trade together because they
are exposed to the same economic drivers – in particular the housing cycle.
As the outlook for housing improves, both stocks typically will perform well because customers are
remodeling their kitchens and replacing broken appliances, hoping to increase the value of their homes in
anticipation of profiting from a sale in the future.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahho! Finance.
Let’s assume for a moment that an investor believes that housing is about to improve in the U.S., and as
a result she conducts rigorous analysis to conclude that both Home Depot (HD) and Lowes (LOW) should
benefit. Based on her analysis, she feels that HD could rise by 25% and LOW by 20% in 2013.
Both stocks offer our investor a very healthy return, and buying both will increase the number of stocks in
her portfolio, yet she chooses to only buy HD.
Since both stocks are highly dependent upon the housing cycle, both stocks will feel pressure when
housing weakens. These two stocks are highly correlated so had she purchased both, she would have
achieved less diversification than one may expect.
NOTE: Correlation is a measure of how two securities move relative to each other. Securities that exhibit
high positive correlation tend to move in tandem, and those with high negative correlation tend to move
opposite of one another. See the link below to learn more about this powerful concept in finance.
The bottom line is that diversification is achieved when a portfolio contains a large number of high quality
securities that are fundamentally different from one another in some way.
How We Diversify
An appropriate way to achieve proper diversification is to dissect each investment into various factors.
For example, Microsoft (MSFT) can be viewed from many different angles. Sure they are a technology
company, but they also pay a dividend, have lower growth today than 15 years ago, and they make
money in several continents.
Examples of segmentation include:
 Sector: Many sectors trade together, such as utilities and telecom, due to their defensive nature.
Too much concentration to a sector or sector theme (defensive vs. cyclical) can leave an investor
exposed if that sector or sector theme runs up in price too far too fast.
 Asset Class: Often times bonds will trade opposite to equities so too much exposure to one can
leave an investor exposed to the downside. A proper mix is warranted between the two.
 Style: Too much exposure to growth stocks can be detrimental if the market makes growth stocks
expensive. However the same goes for value stocks so owning a blend can protect an investor.
 Geography: Too much exposure to one country leaves an investor vulnerable. Diversifying
across geographies lowers the adverse effects of too much exposure to a weakening economy.
Segmenting each security can give an investor insight into their true level of diversification. For example,
if an investor was concerned that the economic issues in Europe were to persist for some time, this
exercise could highlight securities that are highly dependent upon Europe for revenues.
Lastly, diversification is not a “set it and forget it” strategy. An investor must constantly monitor their
portfolio because risk factors change over time, just as companies change over time. Back in 2008,
Apple’s revenues in Asia were quite small but today Asia accounts for over 20% of all revenues.
To learn more about correlation, click on the link below or copy and paste into a web browser:
http://www.compleatadvisor.com//images/files/weekly_thought/Thought_for_the_Week_-_248.pdf
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Yahho! Finance.