This is a very easy-to-understand article that discusses the question: Should investment portfolios be concentrated or diversified? To what extent should they be diversified?
Original article link: https://mp.weixin.qq.com/s/htulXtb9o4-_HiA3AubZPA
Looking back at the investment journey since 2012.
The period from 2012 to early 2015 can be considered as a phase where stock holdings were highly concentrated. Most of the time, only two or three companies were held, and at times, there was even only one company. Because there was a salary income at that time, which could cover family expenses, this highly concentrated holding method was not a big problem at that time.
After early 2015, as the market quickly heated up, the position also quickly decreased, and the cash portion mainly participated in various arbitrage opportunities. Until the second half of 2015, this pattern continued. At that time, the market was in a hot state, and the index continued to rise. During that period, buying was always right and selling was always wrong. Futures often had premiums, and there were frequent risk-free arbitrage opportunities of around 1-3% per week. Moreover, the fund capacity and liquidity were still good. Now it seems that making 1-3% per week is like money falling from the sky. But at that time, most market participants didn't pay much attention to it, otherwise the arbitrage space would quickly shrink. During that period, we continued to reduce our positions, and the position decreased from over 100% (bond repurchase leverage) to 100%, and by June, the position had been reduced to around 10%. Thanks to this arrangement, the two stock market crashes in 2015 did not have any negative impact on our net worth. On the contrary, during the most severe period of the stock market crash, our net worth reached new highs.
After the second half of 2015, the focus gradually shifted to Hong Kong stocks. Because I was not very familiar with the Hong Kong stock market, and I had stepped on a landmine in 2012 (Doctor Frog 01698), I had some psychological shadows. At the same time, after resigning, the lack of fixed income also strengthened my conservative mindset to a certain extent. So when I realized that there were opportunities in Hong Kong stocks, although the position was constantly increasing, the holdings were quite diversified. Many positions were below 10% or even 5%. By the third stock market crash in early 2016, the position was fully invested, and the number of holdings had exceeded 20. Of course, it cannot be said that this diversified investment model is necessarily wrong. It depends on the individual. The best investment model is the one that suits oneself. The popular investment strategy "Guanyucai" on Snowball is based on this model. He summarized it as buying undervalued stocks and averaging up, which is logically sound and has achieved good results. From the second half of 2015 to the first half of 2018, I basically invested in this model. I bought many stocks without deep understanding, without weighing the expected returns and opportunity costs between different stocks, and without differentiating the positions based on risk-reward ratios. I sprinkled pepper, a little bit of everything. The result was that the investment portfolio had both high-performing stocks and underperforming stocks, but because the holdings were not significant, the impact was not significant. It was quite frustrating to buy high-performing stocks but not benefit much due to the small position. In the past three years, although I didn't lose money and the absolute returns were not bad (about 100% in three years), I felt increasingly dissatisfied. This is not a model that suits me. So recently, I have been thinking about concentration, diversification, and buying criteria.
What is the purpose of diversification? It is to mitigate the destructive impact of black swan events on investment portfolios. If the entire portfolio is invested in one stock, and that stock is Doctor Frog, then the impact would be devastating. Therefore, moderate diversification is necessary.
To what extent should diversification be? Many studies by scholars have shown that in the US securities market, when the number of stocks in an investment portfolio reaches 15, the non-systematic risk of the portfolio tends to zero (we do not need the air we breathe to be 100% pure, just like we do not need to completely eliminate non-systematic risk). When the number of stocks in an investment portfolio reaches 8 or more, non-systematic risk can be eliminated to about 90%. According to our research, in the Chinese securities market, when the number of stocks in an investment portfolio reaches 5-10, more than 90% of non-systematic risk can be eliminated.
The italicized part in the previous paragraph and the content in the table are from an article titled "Empirical Study on Diversification of Investment to Reduce Portfolio Risk" published in the Journal of Northeast University of Finance and Economics in November 2001, by authors Jiang Maosheng and Zhang Xueli. The table is based on empirical research conducted by the authors using historical data from the Chinese securities market. The content of the table shows that when the number of stocks reaches 8, the standard deviation of the portfolio no longer shows a significant downward trend. I have not verified the quantitative analysis in the article, so math geniuses can calculate it themselves. Overall, I believe this conclusion is reliable.
Why shouldn't diversification be too excessive? Let's take a look at Warren Buffett's classic statement on this issue in 1965: "To be honest, if there were 50 different investment opportunities in front of me, each with a mathematical expected value that outperformed the Dow Jones Industrial Average by 15% per year, that would be great. If the expected values of these 50 investment opportunities are unrelated, I can divide our funds into 50 parts, invest 2% of the funds in each opportunity, and then be worry-free, because our overall performance will be very close to outperforming the Dow Jones Industrial Average by 15%, which is highly certain. But that's not the case. After a lot of hard work, we can only find a few investment opportunities that are particularly likely to make money. According to our goal, for such investment opportunities, my requirement is to have a mathematical expected value that outperforms the Dow Jones Industrial Average by at least 10%. There are not many opportunities like this, and among the opportunities we find, there are significant differences in the mathematical expected values of each. We always have to answer this question: "How much position should be allocated to the investment opportunity that ranks first in terms of relative returns? How much position should be allocated to the investment opportunity that ranks eighth?" This mainly depends on how much difference there is in the mathematical expected values between the first and eighth, and also consider how likely it is for the first to have extremely poor relative returns. The mathematical expected values of two stocks may be the same, but one has a 5% probability of lagging behind the Dow Jones Industrial Average by more than 15%, while the other has only a 1% probability of this happening. The former has a wider range of mathematical expected values, which will reduce my willingness to concentrate on investing in that stock." Buffett's point is simple, there simply aren't that many investment opportunities with the same high expected returns.
From the perspective of reducing non-systematic risk through diversified holdings, the decrease in non-systematic risk becomes very slow or even negligible after diversifying into 8 or 10 stocks. There is simply no need to diversify into more than 8 or 10 stocks. Excessive diversification only reduces the expected return of the portfolio, with little effect on reducing non-systematic risk.
To summarize: for the concentration and diversification of investment portfolios, moderate diversification with 5-8 stocks is sufficient. In cases where there is a strong certainty (small potential losses) and outstanding expected returns, 3-5 stocks are also acceptable. Only through concentrated investment is it possible to find listed companies worth holding even if they are not listed, without losing the expected return rate as much as possible.