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Diversification - why it matters

DividendGuy67
Publish date: Sun, 01 Sep 2024, 10:40 PM

Background

In another chatgroup, there was an interesting discussion today about diversification.

Someone famously quoted Buffett who said "Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing."

I shared my own views there, and after the chat, I was curious what ChatGPT would say on this topic, so, I asked ChatGPT a few questions and here are its answers.

ChatGPT's opinions on diversification

Question 1 - ChatGPT, why do I need to diversify my stock portfolio?

Diversifying your stock portfolio is crucial for managing risk and enhancing potential returns. Here’s why:

  1. Risk Reduction: By spreading your investments across different stocks, sectors, or asset classes, you reduce the impact of poor performance from any single investment. If one stock or sector underperforms, the overall effect on your portfolio is less severe if other investments are performing well.

  2. Mitigating Volatility: Different stocks and sectors often react differently to market conditions. For example, technology stocks might perform well when the economy is strong but struggle during a downturn, whereas consumer staples might be more stable. Diversification helps smooth out the ups and downs of your portfolio.

  3. Enhanced Returns: A diversified portfolio can capture gains from various segments of the market. While you may not benefit as much from the extraordinary performance of a single stock, your overall returns can be more stable and consistent.

  4. Protection Against Unpredictability: Markets are unpredictable, and diversification helps protect against unforeseen events that might negatively impact specific investments. For example, if a company faces legal trouble or a sector faces regulatory changes, having investments in other areas can provide a buffer.

  5. Long-Term Growth: Over the long term, diversified portfolios tend to perform better because they are less susceptible to the dramatic swings that can affect more concentrated portfolios. This can lead to more stable growth and a smoother investment journey.

In essence, diversification is like not putting all your eggs in one basket. It helps balance potential risks and rewards, making your investment strategy more resilient and adaptable to changing market conditions.

Question 2 - ChatGPT, why can't I concentrate on stocks I know?

Focusing solely on stocks you're familiar with might seem like a smart approach, but it comes with several limitations that can impact your investment success. Here’s why:

  1. Limited Perspective: Relying only on what you know can narrow your view. Markets and industries evolve, and staying within a comfort zone might mean missing out on promising opportunities in other sectors or emerging technologies.

  2. Concentration Risk: Investing heavily in a few familiar stocks can expose you to higher risk if those companies or sectors face difficulties. If your portfolio is concentrated in just a few stocks or industries, any negative event affecting those areas can have a significant impact on your overall portfolio.

  3. Lack of Diversification: Diversification helps manage risk and smooth out returns. By focusing only on familiar stocks, you may miss the benefits of diversification across different sectors, asset classes, or geographic regions.

  4. Potential Bias: Familiarity can lead to bias. You might overestimate the potential of stocks you know well or overlook their weaknesses. This can cloud your judgment and lead to suboptimal investment decisions.

  5. Missed Opportunities: The market is full of opportunities outside your usual realm of knowledge. By diversifying into areas you’re less familiar with, you can potentially discover high-growth investments that you wouldn’t have considered otherwise.

  6. Changing Market Conditions: Market dynamics can shift rapidly. Stocks or industries that are strong today might not perform well in the future. Relying only on what you know might make your portfolio less adaptable to changing market conditions.

In short, while investing in familiar stocks can be part of your strategy, a well-rounded approach that includes diversification can help mitigate risks and enhance your potential for long-term success.

Question 3 - ChatGPT, what if I analyze really really well?

If you’re skilled at analyzing stocks and feel confident in your ability to pick winning investments, that’s a valuable asset. However, even the best analysts can face challenges that diversification helps mitigate. Here’s why diversification remains important, even with strong analytical skills:

  1. Unpredictable Markets: Despite thorough analysis, markets can be unpredictable due to factors beyond your control, such as macroeconomic changes, geopolitical events, or sudden shifts in investor sentiment. Diversification helps protect your portfolio from these unpredictable elements.

  2. Analysis Limitations: Even the most rigorous analysis has limitations. Data can be incomplete or subject to interpretation, and unforeseen events can impact stocks in ways that are hard to predict. Diversification helps cushion your portfolio against potential errors or gaps in your analysis.

  3. Sector and Industry Risk: Even if you excel in analyzing specific sectors or industries, those areas can be affected by sector-specific risks. Diversifying across different sectors and asset classes can help reduce the impact of negative developments in any single sector.

  4. Bias and Overconfidence: Even skilled analysts can fall prey to biases, such as overconfidence in their own predictions. Diversification acts as a safeguard against the risk of making overly concentrated bets based on potentially biased or overly optimistic analyses.

  5. Market Dynamics: The market environment is constantly changing. What works well in one market condition might not perform as expected in another. Diversification helps ensure that your portfolio is not overly reliant on a particular market trend or condition.

  6. Opportunity Cost: Focusing solely on a few stocks, no matter how well-researched, might lead you to miss out on other opportunities that could contribute to overall portfolio growth. Diversification allows you to capture gains from a broader range of investments.

In essence, while strong analytical skills are a tremendous advantage, diversification provides a safety net against unforeseen risks and ensures a more balanced approach to investing. It helps manage risk and smooth out returns, complementing your analytical prowess with a robust strategy.

Question 4 - How many stocks should I diversify?

The ideal number of stocks to hold for effective diversification can vary depending on several factors, such as your investment goals, risk tolerance, and investment strategy. However, there are some general guidelines that can help:

  1. Basic Diversification: For most investors, holding between 15 to 30 individual stocks can provide a good level of diversification. This range helps spread risk across different companies and sectors while still allowing you to manage and monitor your investments effectively.

  2. Optimal Diversification: Research suggests that a portfolio of around 20 to 30 stocks can achieve significant diversification benefits. Beyond this number, additional stocks may offer diminishing returns in terms of risk reduction.

  3. Sector and Industry Balance: It’s not just the number of stocks that matters, but also how they are distributed across sectors and industries. A well-diversified portfolio should include stocks from various sectors to reduce sector-specific risk.

  4. Alternative Investments: Consider diversifying beyond stocks into other asset classes, such as bonds, real estate, or commodities. This broader approach can further reduce risk and enhance portfolio stability.

  5. Mutual Funds and ETFs: If managing a large number of individual stocks feels overwhelming, you can achieve diversification through mutual funds or exchange-traded funds (ETFs). These funds pool investments into a wide range of stocks and other assets, providing built-in diversification with a single investment.

  6. Personal Preferences: Your personal preferences and investment strategy will also play a role. Some investors prefer to focus on fewer, high-conviction stocks, while others may choose a broader approach to ensure diversification.

In summary, aiming for 15 to 30 individual stocks can help you achieve a diversified portfolio, but also consider diversifying across asset classes and using funds to achieve a broader diversification. The key is to balance the number of stocks with how well you can manage and monitor them, ensuring that your portfolio aligns with your overall investment goals and risk tolerance.

Question 5 - What should be the criteria for Diversification?

When diversifying your investment portfolio, it's important to establish criteria that align with your investment goals, risk tolerance, and strategy. Here are key criteria to consider for effective diversification:

  1. Sector and Industry Diversification:

    • Avoid Concentration: Spread your investments across different sectors (e.g., technology, healthcare, consumer goods) to reduce sector-specific risk.
    • Balance Industry Exposure: Ensure you’re not overly concentrated in a single industry within a sector, as industries can also experience unique risks and trends.
  2. Geographic Diversification:

    • Domestic vs. International: Consider investing in stocks from different regions or countries to mitigate risks associated with any single country's economic conditions or political events.
    • Emerging Markets: Depending on your risk tolerance, including some exposure to emerging markets can offer growth opportunities but also comes with higher risk.
  3. Company Size and Type:

    • Market Capitalization: Diversify across different market capitalizations (large-cap, mid-cap, and small-cap) as they can perform differently depending on economic conditions.
    • Growth vs. Value: Balance between growth stocks (high potential for growth but may have higher volatility) and value stocks (typically more stable but may offer lower growth).
  4. Asset Classes:

    • Beyond Stocks: Consider diversifying into other asset classes such as bonds, real estate, commodities, or cash. Each asset class has different risk and return characteristics and can provide stability during market fluctuations.
    • Alternative Investments: Depending on your investment strategy, you might also explore alternative investments like private equity, hedge funds, or cryptocurrencies.
  5. Investment Styles and Strategies:

    • Active vs. Passive: Mix actively managed investments with passively managed ones (like index funds) to balance between potentially higher returns and lower costs.
    • Income vs. Growth: Include investments that provide income (dividends, interest) as well as those that focus on capital appreciation (growth).
  6. Risk and Volatility:

    • Volatility Tolerance: Assess your comfort with volatility and adjust your portfolio accordingly. More volatile assets might offer higher returns but come with increased risk.
    • Correlation: Aim to include investments that are not highly correlated with each other. This means their prices do not move in sync, which helps in reducing overall portfolio risk.
  7. Time Horizon and Investment Goals:

    • Short-Term vs. Long-Term: Align your diversification strategy with your investment time horizon. Short-term investors may focus more on stability, while long-term investors might include more growth-oriented assets.
    • Objective: Tailor your diversification based on your goals, such as retirement savings, capital preservation, or income generation.
  8. Liquidity:

    • Ease of Selling: Ensure that a portion of your portfolio includes investments that are easily tradable and liquid, which provides flexibility to react to market changes or personal financial needs.

By applying these criteria, you can build a diversified portfolio that balances risk and potential return, while aligning with your financial goals and investment strategy.

Question 6 - Who said diversification is for those who doesn't know what they are doing? Is it true, false or somewhere in between?

The quote you’re referring to is often attributed to Warren Buffett, who famously said, “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.” This statement reflects Buffett’s view on diversification as it relates to investing in individual stocks versus holding a broader range of investments.

Truth or Falsehood?

  1. Context Matters:

    • Buffett’s Perspective: Warren Buffett is known for his focus on high-quality, well-researched investments. His approach suggests that if you thoroughly understand and can confidently assess a few companies or investments, concentrating your investments in those could yield higher returns. Buffett himself has often emphasized investing in what you know and understand deeply.
  2. For the Average Investor:

    • Risk Management: For most individual investors, diversification is a key strategy for managing risk. The average investor may not have the time or expertise to deeply analyze and continuously monitor a small number of stocks. Diversification helps spread risk across a broader range of investments, which can help reduce the impact of poor performance in any single investment.
  3. Diversification vs. Concentration:

    • Different Strategies: Diversification is a strategy aimed at reducing risk by investing in a variety of assets. It’s a common and prudent approach for many investors, particularly those who may not have the resources or expertise to pick individual stocks with high conviction.
    • Concentration: Conversely, concentrated investing involves putting a larger portion of your capital into a smaller number of investments that you believe in strongly. This approach can potentially yield higher returns but also comes with higher risk, as poor performance in a single investment can significantly impact your overall portfolio.
  4. Middle Ground:

    • Balance: For most investors, a balance between diversification and concentration is ideal. Diversifying across different sectors, industries, and asset classes while also maintaining some focus on a few well-researched investments can provide both risk management and the opportunity for higher returns.

In essence, the view that diversification is only for those who don’t know what they’re doing is not entirely accurate. Diversification is a foundational principle of risk management and is widely used by both individual and institutional investors. However, for experienced investors who have a deep understanding of their investments, a more concentrated approach may be appropriate, though it carries its own set of risks. The key is to find a strategy that aligns with your investment knowledge, risk tolerance, and goals.

Summary and Conclusion

So, what's your takeaway from listening to ChatGPT?

I find its answers fascinating.  Surprisingly, quite aligned with my own personal views.  Hard to pinpoint one view where I strongly disagree.  Maybe 20-30 stocks.  I find 30 is still not sufficiently diversified across so many different areas.  I have closer to 50, but I can manage 50 quite easily and if you can't, then, try to find the right balance.

My beliefs on diversification is cemented after a terrible personal experiencePeople change when they are forced to change and it's the same with me.  Prior to that, I believed so much in this wonderful stock called "AIG" (American International Group).  My beliefs is grounded on facts, both fundamentals and technicals.  From the 1970s till 2007, AIG stock price is everybody's dream, regardless of what type of investor and trader you are, whether fundamental, technical, hybrid, etc.   Fundamentally, the business kept delivering steady returns year after year after year.  Technically, the chart is perfect throughout these 3 decades.  See the price chart of AIG during this period.

For you to understand how consistent and how good it is over 3 decades, it turned $10 into nearly $2000!  Definitely over 100 bagger!  

Additionally, during this period:

  • All analysts and institutional investors only have good things to say about this stock year after year - for over 3 decades.  Can you imagine this?  
  • Rating agencies like Moody's, Standard & Poors concurred with these IBs with only good things to say about AIG.  Nobody had bad things to say.

And unfortunately for me, by 2007, I believed it so much, that like so many people then, I had allowed 35% of my entire net worth in that one  stock.  I failed to consider that I might not have diversified as much as I should.

And what transpired in a very short time during the GFC?  It fell faster than I could react.  Complete disbelief how 3 decades of growth turned into a huge disaster in just one year, wiping out 99% of its value!!!  Remember, AIG was a Dow Jones component, the best stock globally, viewed and analyzed by every analyst globally!  Here's what the chart looked like.

I remembered the market was in huge disbelief.  

I was in huge disbelief.  

After all, I "knew" the fundamentals of AIG best compared to all stocks.  The charts also.

Yet, as it turned out, my knowledge was limited.  My data was limited.  The whole world's data was limited.

As what ChatGPT says - all analysis have limitations.

Later on, I discovered the knowledge gaps.  Of course by then it was too late.  More than a third of my entire Net Worth was wiped out permanently, because I did not diversify sufficiently.  

It was a super expensive lesson.

What was the lesson?  Diversification.  After that huge loss, I resolved never to ever again subject myself to concentration.

In short - diversify especially when you have only another 10-20 years to retirement and if you are now in your 40s and definitely in your 50s and a must as you enter 60.  Because all analysis have limitations.  No matter how good an analyst you are, markets are unpredictable and re-read the good advise from above.


Disclaimer:  As usual, you are solely responsible for your own trading and investing decisions.

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