Diversification, diversification, diversification

Friday, 14th July 2017 15:53 - by Eric Chalker

 Diversification should surely be the number one rule for private investors, yet too often it is forgotten, or simply ignored in pursuit of an overwhelming belief in a particular stock.  This week those who broke the rule when previously buying shares in Carillion found out the hard way, as one member of the London South East share chat community certainly did.  Holding nearly 85,000 Carillion shares, he declared himself “very stressed”, which must surely be because his holdings weren’t sufficiently diversified.

Chart followers will have seen the Carillion share price on a downward path for the past two years and may even have been aware that it was the most heavily shorted stock.  Even so, this is not to say that investing in Carillion was obviously wrong, not least as there were many who took the opposite view.

In April 2015 The Share Centre told clients, “Carillion has long been (a) favoured stock”.  In August 2015 Questor in The Daily Telegraph told readers “Carillion remains a buy.”  In October 2015, JP Morgan Cazenove upgraded Carillion to “overweight”.  It was actually tipped as a “buy” by Investors Chronicle on no less than eight occasions between December 2014 and March 2017; the first of these was a major recommendation and the last was headed “Carillion’s reasons to be cheerful.”  The respected Bearbull column did express doubts in October 2016, but concluded it was still worth holding for the dividend. 

A disastrous decision ten years ago

Early in 2007, almost every share commentator was advocating Northern Rock as a good income share.  As we all know, within a year the share price had collapsed and Northern Rock passed into state ownership with nothing for its shareholders.  The UK Shareholders’ Association ran a campaign for those dispossessed investors, to which huge numbers responded.  Many sad stories came to light.  One, perhaps the worst, was about a man who, having a large house but being income poor, sold the house and bought Northern Rock shares with the proceeds: being completely undiversified, he lost everything.

Diversification is the name of the game

As I wrote in an earlier blog (“Carillion rings an uncertain tune” 13th Sep 2016), I then held Carillion shares in a portfolio that I manage which I still hold as I write.  This is despite the doubts I expressed to Philip Green, the chairman, in correspondence I reported in the blog, which are now seen to be completely valid.  I have repeatedly asked myself whether I should keep the shares and now of course wish I had sold.  However, the point of today’s blog is that immediately before the collapse Carillion was only 4.6 per cent of the portfolio.   Because this portfolio, comprising 13 stocks in all, is well diversified, the loss is contained.  That is the point: diversification is the name of the game. 

The “very stressed” chat writer mentioned above bought at £2.06, which is substantially less than I paid, but he reported his loss, mid-afternoon on Monday, as roughly £70,000, which for most private investors would be massive.   The question must be, why did he put so much money into a single stock?  To be properly diversified at this level would imply a portfolio worth over a million pounds, but if one has that amount of money the loss of even £70,000 should not cause serious stress, because all values are relative.  For this reason, without knowing the investor concerned, I conclude that he was not diversified, or at least not enough.  Even with sustained buying recommendations by Investors Chronicle and others, to have risked an excessive part of his wealth in a single stock has to have been wrong.

Containing one’s losses

What is excessive risk?  It has to involve a sum the loss of which would cause enough financial pain to make one “very stressed”.  The figures will vary from investor to investor, but the principle is the same.  All shares are inherently risky because all businesses are inherently risky, for a whole variety of reasons some of which are completely unpredictable.  Some losses are therefore to be expected when investing in shares, but with a reasonable degree of application these should be relatively small and the gains should more than offset them.  This is providing shares are held in a sufficient variety of companies.

No equity investment can be guaranteed, so for both income and capital appreciation investors must spread their risks.  The smallest number of stocks to hold is five, but that is just for fun.  My rule of thumb when advising family and friends is never have less than ten stocks and twenty is better, each in a different sector.  For large sums of money, the number of diversified stocks held should be larger, to spread the risk and avoid having too much money in a single stock (see my blog, “Harvesting the profits” 1^st June 2017).

The benefit of restraint

One is sometimes tempted to think that one particular share will turn out to be worth many times what has been paid for it, so more of these shares are bought until the portfolio becomes seriously unbalanced and serious money is at stake.  It may work out well and in that case congratulations will be in order, but it often doesn’t and then large sums are lost which can make one “very stressed” indeed.  I know, I have done it and would like to think I’ve learned the lesson, but the temptation to believe a fortune is within one’s grasp is always there.  The benefit of restraint is minimised losses, because if no investment is allowed to grow too much, what is at risk of loss can never grow too big.

When Carillion’s shares were at £2.06, the expected dividend yield was roughly 9 per cent.  At that point I should perhaps have sold, but as Carillion even then was no more than 5 per cent of the portfolio it was relatively painless to hold on for the possibility that the share price would recover.  Good diversification enabled me to do this and, for the same reason, the loss of value since then, while disappointing, is tolerable and causes no stress.  I repeat, diversification is the name of the game.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.