September 13, 2019

‘Königs-Prinzip’ of Portfolio Review: Diversification

Portfolio maintenance for long-term investors is very simple. Long-term investors don't try to beat the market in the short term because they know it's impossible, not even the world-famous investor Warren Buffet tries to do this.

Long-term investors certainly don't care about the so-called modern portfolio theory of Markowitz. Harry Markowitz was awarded the Nobel Prize for this, but when it came to his own portfolio management, he didn't use about it, because he probably knew that its theoretical elegance could hardly be put into practice because important inputs for it were not observable at all. If Harry Markowitz doesn't use his modern portfolio theory, you don't have to either.

Long-term investors only have to do one thing when maintaining portfolios: compare the advantages of diversification with the efforts of holding many shares simultaneously. In German, we call this the ‘Königs-Prinzip’, the leading principle of portfolio maintenance. The more shares you have, the better you are diversified, the lower the risk, but the higher the maintenance effort.

You can diversify stocks in two ways: by region and by industry. The Norwegian financial economists Paul Ehling and Sofia B. Ramos have shown that both are needed. Unfortunately, there are no clear principles for either one.

As far as the region is concerned, it is unclear which region a stock can be assigned to at all. Is Nestlé a Swiss stock if 98% of sales are generated abroad? Apple is also not a pure US stock, because here, too, production and distribution are largely outside the United States.

It's not easier with industry diversification. Are airlines and coach companies in the same industry? Both are in the travel industry. But if the pilots go on strike, the coaches benefit. In this sense, coach companies are a good diversification for airlines and therefore not in the same industry.

Nevertheless, as an investor, you have to decide how much money you want to invest where. Here, the simplest solution, namely equal weighting of investments, is also the best one. That's what former UBS chief economist Klaus Wellershoff published in his latest book. His high-caliber team at the World leading Swiss bank has tested a wide variety of weighting methods and found that equal weighting is the winner. The US broker Bridgewater came to a similar conclusion after analyzing a whole century of equity investments in global markets. Although the US market was the best in the century under review, a globally equal-weighted portfolio would have produced virtually the same result. This is possible because while global markets outside the US such as France, England, and Germany suffered the world wars, their recovery afterward yielded unique returns that compensated for the crises.

In my opinion, there is one good basic rule. Make sure that your portfolio is not concentrated in a single region or industry. Then you are quite well diversified.

When it comes to the number of stocks needed in your portfolio, scientists have found a lot more. Meir Statman from the University of Washington recommends at least thirty shares, better forty to fifty.

But that doesn't mean you have to own at least thirty shares right from the start. First, you buy only one share and only with a small portion of perhaps two to five percent of your assets. After one month, you buy another share and so build up your diversified portfolio.

If you don't have a large amount to invest, but simply want to put something aside every year, it's even easier. Obermatt CEO Dr. Hermann J. Stern recommends investing two to four times a year. So after one year there are four shares in your portfolio and after five years you already own twenty shares, the start of being diversified.

You can argue that you are not diversified at the beginning. But that's not true, because you have to take the whole investment amount into account for comparison, including the future money that still will be invested. So the investment amount in the first stock is only a very small fraction of all future investments.

The Königs-Prinzip of portfolio review, the leading principle to follow is thus:

  • Make sure that you have many, broadly diversified stocks, in the end there should be more than thirty
  • Invest in large companies, because these companies are already diversified by their operational activities.
  • Sell the small shares in the portfolio, because these are not worth the effort

Don't try to find the best time to buy and sell, because it doesn't exist. Just remember that you need to be broadly diversified and balance the number of shares against the effort it takes to maintain them.

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