How much diversification is enough?
A couple of articles that I've written recently have prompted a debate among some readers -- even among those holding only FTSE 100 (UKX) stalwarts. In short, to what extent should you diversify?
At first glance, the question seems odd. Again and again, investing beginners are told, diversification is good.
But is it? As I wrote the other day, under-the-radar investment legend Seth Klarman currently has 40% of his $2.9 billion portfolio in just three shares.
Nor is Warren Buffett a fan. "Do not put your eggs in many baskets," he's on record as saying. "Put all your eggs in one basket -- and proceed to watch that basket very carefully."
The trouble is, I reckon that the question itself is flawed. For asking the question 'how much diversification is enough?' omits any consideration of the investors' objectives.
A gung-ho capital growth investor, for instance, will almost inevitably want to minimise diversification, so as to maximise investment gains.
If a share doubles in value, and it's simply one of 20 that you hold, then the overall impact on your portfolio is a gain of 5%. If your portfolio is 10 shares, the same doubling is a 10% gain overall.
Go the whole hog, and put all your eggs in one basket, then the doubling of that single share represents a portfolio growth of 100%.
Income investors approach things from a different perspective, though.
With a one-share portfolio, a 50% dividend cut in a single share reduces annual income by 50%. With a five-share portfolio, a 50% dividend cut in a single share reduces annual income by 10%.
But with a 20-share portfolio, a 50% dividend cut in a single share reduces annual income by 2.5%.
I know which I prefer. My own income portfolio, for what it's worth, stands at 15 shares -- about halfway to the eventual number that I want.
That said, investors pursuing a cautious, in-between strategy -- dividends are good, but so are capital gains -- can more safely concentrate their portfolios by avoiding sector duplication.
Hold one bank, not two, in other words -- no matter how appealing the financial sector. Ditto oil companies, supermarkets, pharmaceutical firms and so on.
67% of the FTSE
What might such a portfolio look like in practice? Take a look at this selection of five picks, each one chosen for reasonable fundamentals, reasonable prospects, and limited overlap with the other sectors.
|Company||Current price||Market cap||Forecast P/E||Forecast yield|
|Royal Dutch Shell (LSE: RDSB)||2347p||£144.7bn||8.2||4.9%|
|BAE Systems (LSE: BA)||332p||£10.5bn||7.8||6.4%|
|Unilever (LSE: ULVR)||2267p||£64.1bn||16.2||3.6%|
|GlaxoSmithKline (LSE: GSK)||1474p||£72.2bn||11.7||5.3%|
|HSBC (LSE: HSBA)||568p||£103.4bn||8.8||5.3%|
Now, five sectors won't cover the full range of the FTSE (UKX), by any means. Even so, the sectors I've selected, in fact, amount to a fairly impressive 67% of the FTSE All-Share index. And viewed as five individual shares, they collectively make up 19% of the FTSE 100.
How diversified are they? Granted, 'limited overlap' has, well, limitations. A recession, for instance, bites hard into consumer purchasing power, affecting every sector that is dependent on consumer discretionary spending. Even so, the products that these businesses sell for the most part fall firmly into the 'non-discretionary' category.
- Royal Dutch Shell operates in 80 countries around the world, operating over 30 refineries and chemical plants, and produces 3.2 million barrels of gas and crude oil each day. Global revenues amounted to $470 billion during 2011 -- some of which came from the company's 43,000 retail filling stations around the world, of course, but also from industrial customers of its chemicals and gas businesses.
- BAE Systems has expanded far beyond its aerospace roots to become something of a defence‑related 'one stop' shop, with military aircraft, surface ships and submarines, tanks and other combat vehicles, ordnance, electronic warfare and missile systems all on offer. The bulk of the company's sales go to the governments and defence ministries of its five 'home markets' -- Australia, India, Saudi Arabia, the UK and the United States.
- Two billion consumers use a Unilever product every single day, with Unilever products being sold in over 190 countries worldwide. And those products are themselves almost prefect diversified, both by geography and type. Foodstuffs, cleaning products, oral care, personal hygiene: sales of Unilever's clutch of global brands come 33% from the Americas, 29% from Europe and 38% from Africa and Asia.
- GlaxoSmithKline isn't just the world's second largest pharmaceutical company, employing around 99,000 people and manufacturing almost four billion packs of medicines and healthcare products every year. It's also a consumer business with a robust collection of strong brands: Ribena, Horlicks, Lucozade, Aquafresh, Sensodyne, Panadol, Tums, Zovirax -- and of course, the Macleans range of toothpaste, mouthwash and toothbrushes.
- HSBC serves around 60 million customers worldwide, through 6,900 branches and offices in 84 countries. With a strategy of being "the world's leading international bank", HSBC has the distinction of having paid out more in dividends than any bank in the world over the past five years.
Want to know more? Two of these shares, as it happens, are profiled in a special free report from The Motley Fool -- "Top Sectors Of 2012" -- which pinpoints 17 shares across three sectors tipped for outperformance. Reading it could throw a few more diversification ideas into the mix.
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More investing ideas from Malcolm Wheatley:
> Malcolm owns Unilever, BAE Systems, and GlaxoSmithKline. He does not have a beneficial interest in any other share mentioned.