Portfolio diversification, the only free lunch in investing?
“The only investors who shouldn’t diversify are those who are right 100% of the time.”
Sir John Templeton
Each time just before a company announces bonus, share split, and free warrants, investors are elated and the stock price jumps. Are these stuff really “free”? My response to this question is:
Waiter: Do you want to slice your pizza to 5 pieces or 10 pieces?
Me: No, 20 pieces please. I am very hungry.
Simply said, there is no free lunch in the stock market. One just cannot create something out of nothing. But that is the mentality of most investors in Bursa. It is hence a viable strategy to make use of this psychology of investing, the cognitive bias of mental accounting of the masses; buy when there is a bonus issue or share split, come with “free warrants”, preferably getting some insider information first, and sell later after the share price has been chased up before the share price reverts to its mean.
But wait, many academicians do believe there is a kind of free lunch in the market, i.e. in portfolio diversification. The popular adage of "Don't put all your eggs in one basket" is very much suited for investing in the stock market. It advocates diversification, a technique that reduces risk by allocating investments in a number of stocks in the portfolio. Ideally the stocks chosen should be spread over different industries that would each react differently to the same event.
As the number of stocks in the portfolio increases, the variation of return reduces sharply initially as shown in Figure 1 below. Studies and mathematical models have shown that maintaining a well-diversified portfolio of about 20 stocks will yield the most cost-effective level of risk reduction as shown in the figure below.
Figure 1: Reduction of idiosyncratic risk
Modern Portfolio Theory by the Nobel Laureate Harry Markowitz has shown that when you have stocks that have low correlations together in a portfolio, you may be able to get more return while taking on the same level of risk, or the same returns with less risk as shown on the efficient frontier in Figure 2 below. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return.
Figure 2: Efficient frontier
Stocks diversification won’t ensure gains or guarantee against losses but strives to smooth out unsystematic risks of companies in a portfolio which are not perfectly correlated so that the positive performance of some companies will neutralize the negative performance of others. Stock diversification appears to be the only free lunch in investing.
