Risk is not Danger

September 7, 2012

There is a great deal of disagreement among portfolio specialists about the notion of diversification. Some experts feel perfectly safe with a 20-stock portfolio, while at the other end of the spectrum, firms like PWL build portfolios made up of thousands of securities. This article looks at why we are insistent that extreme diversification is the right thing for investors.

What is portfolio diversification?
Diversification means that if several securities are combined within a portfolio, those that lose money during any period of time will be offset by those with positive returns. Overall, this results in the same average long-term expected return, but with less risk. Academic research in the U.S. has found that generally, individual investors’ portfolios are not very diversified, containing an average of only three stocks.

What is risk management?
Risk management is not about never losing money. Risk management performs the following functions:

  1. It limits potential losses.
  2. It ensures that a portfolio will recover from the inevitable market downturns that we all experience in our investment lifetime.

The chart below illustrates risk management. In 2008, those who had invested in the S&P500 suffered heavy losses, as did investors in financial companies like Citigroup, AIG and Fannie Mae. But the (diversified) S&P500 portfolio was far more robust: compared to the individual companies, it fell less hard and recovered its value after the crisis ended. In contrast, a concentrated portfolio is exposed to the possibility of large permanent losses.

Naturally for our illustration purposes, we selected some of the most hard-hit companies. But that’s exactly our point: don’t let bad luck steal away your wealth!

Our advice
In terms of the ideal number of stocks in a portfolio, we say that more is better. While an extremely diversified portfolio is still risky (it fluctuates in value), it is not dangerous, in the sense that the investor will not permanently lose a large chunk of wealth overnight. PWL portfolios include over 7,000 stocks, diversified by sector, style, size and geography. For any investor looking for a robust portfolio (risky but not dangerous), that’s as good as it gets.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.