Give Your Portfolio Margin For Error: Diversify, Diversify, Diversify

by: Tim McAleenan Jr.

Plenty of smart people have capitalized on one great idea and made a concentrated bet on their quest to making their riches. As the former steel magnate Andrew Carnegie once said, "Put all your eggs in one basket and watch that basket." And although Warren Buffett's Berkshire Hathaway (BRK.A) (NYSE:BRK.B) owns over seventy operating business and shares of over thirty publicly traded companies, people have often looked to Buffett's quote about how diversification is only for people who don't know what they are doing, "If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice." This approach is also echoed by famed money manager Peter Lynch, who once dubbed the pursuit of diversifying stock holdings "diworsification."

At some level, this makes sense. If you're convinced that Coke (KO) and Johnson & Johnson (JNJ) are positioned for 11% growth in your portfolio, why should you add Colgate-Palmolive (CL), McDonalds (MCD), and Pepsi (PEP) to your portfolio if you own believe they will return 9% annually over the coming decade? It all comes down to margin of safety. It seems foolish to me that anyone would put themselves in the position of being as reliant on the dividend income or performance of a particular stock as many people are on their employer.

If you're a dividend-growth focused investor, why would you put yourself in the position of only receiving income for living expenses from two or three stock holdings when you can instead allow ten different companies to meet those same needs? If one of those two companies goes bankrupt or slashes its dividend, you have no margin of safety-imagine being someone who had the bulk of his or her savings in General Electric (GE) or Wells Fargo (WFC) when the financial crisis hit. If GE or Wells Fargo was only 5% of your portfolio, you could easily weather the storm by relying on your other holdings to pick up the slack-if you owned twenty different blue chip stocks, one or two can defect during a given moment without materially affecting your standard of living.

While all personal finance is subjective and it's difficult to apply one-size-fits-all advice to anyone, I do think there is one question that can serve as a useful proxy for determining whether an investor is diversified enough. The best thing for an investor to do would be to look at each holding and ask the question, "If this stock went completely bankrupt, would this affect negatively affect my lifestyle beyond a level I would be comfortable with?" That question seems to cut to the heart of the need for diversification-if you're a retired investor relying on Chevron (CVX) dividends to meet half of your living expenses, you're most likely not diversified enough. If the price of oil falls to $30 per barrel or if Chevron makes a series of management blunders that lead to a dividend cut, you're out of luck. Considering that many investors seek passive income to remove themselves from having to rely on the income from one entity (an employer), it seems foolish to needlessly create the same relationship with the income from a stock holding-don't you think that the risk of 1-2% lower returns that comes with a 15-20 stock portfolio is worth it if you can eliminate the wipe-out risk that a 4-5 stock portfolio would necessarily create?

In looking at Benjamin Graham's "The Intelligent Investor," Mr. Graham does a fantastic job of explaining the appeal of diversification as a hallmark of the conservative investor's portfolio. On page 518, he makes the case for diversification thusly:

"There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss-not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business. Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin of safety principle, to which diversification is the companion."

This notion that diversification creates an additional layer for your margin of safety seems to make sense. Five years ago, most dividend-focused portfolios contained Bank of America (BAC), Lehman Brothers, and Wachovia. Lehman is gone, Wachovia became a shell of its former self before getting bought up by Wells Fargo for pennies on the dollar, and Bank of America pays out a $0.01 penny dividend as its stock price has crashed. Looking at things today, we know that all three of these companies did very terribly from 2007 on. But who recognized this in 2007? Not very many.

This is where the appeal of diversification comes in. I recently looked at Wachovia's 2007 balance sheet, and I was impressed by what I saw. It wasn't filled with Enron-like scribbles in the footnotes or the opacity that we have come to expect from the likes of Bank of America or Citigroup (C). Instead, it looked like the conservatively run bank that it had been for the previous three decades, paying out a growing dividend that constituted a low to reasonable percentage of the overall profits. While I did not invest in Wachovia, I don't expect to go through my investing lifetime without making any mistakes, and that is exactly what diversification protects you from: yourself. It allows you to have errors of misjudgment and still come out ahead.

Yes, you may sacrifice something in terms of total returns of you own twenty-five stocks instead of five. As Buffett said, you shouldn't expect your 25th best idea in the stock market to perform as well as your single-best idea. But with this sacrifice in mind, you can create a margin for error and afford to shoot a couple blanks without introducing an element of wipe-out risk to your portfolio. If Wachovia and General Electric made up 40% of your portfolio, you would have been absolutely wrecked in 2008. But, if they each made up on 5% of a diversified portfolio, you could easily weather the storm, and the temporary catastrophe would have only been a short-term blip on the screen. You should structure your investments to allow for the greatest margin of error possible so that when you make a misjudgment about a company that you choose to invest in, you can easily continue with business as usual without having to, in the words of Charlie Munger, "go back 'To Go' on the Monopoly board."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.