The great diversification myth

Is buying a stock to improve your portfolio diversification a sensible idea?

It sounds like it. Well-diversified portfolios lower risk by narrowing the range of potential outcomes. And owning stocks in different sectors is a good way to achieve that goal.

Your broker will almost certainly agree. 'You have to own the banks', he'll say, 'because they account for 30% of the market'. Your financial advisor will sing the praises of diversification, too. Trouble is, they're letting diversification – rather than value – drive the buying decision.

Let's assume you asked your broker for stock ideas late last year. After reviewing your portfolio he suggested Monadelphous because you 'need some exposure to mining services'. 'Profit's grown every year for more than a decade', he'd said, 'and you can't go past the company's 56% return on equity'.

Unconvinced, you consult Intelligent Investor Share Advisor for a second opinion. In February you read the review of Monadelphous, with its ominous warning that 'the cyclicality of the business is inescapable'. The Avoid recommendation at $26.35 was based on the 'hefty price to earnings ratio of 17'. Since then the stock has crashed almost 30%.

So buying to 'get exposure' to the mining services sector missed the key point. The sector, and most stocks within it, were poor value in the first place.

Nor do all sectors provide promising investment candidates. Some industries have a reputation for poor economics and are best avoided altogether by long-term investors. Anyone who bought steelmakers, airlines and building materials stocks 10 years ago to 'improve their portfolio diversification' is probably regretting their decision.

Relying on index constituents for diversification is another problematic strategy. Sharemarket indices say nothing about value. Indeed, their nature is that market darlings join the index while poor performers get ejected.

The Australian sharemarket is inherently undiversified. In some sectors, choices are few and far between. Telstra accounts for an incredible 96% of the Telecommunications sector index. CSL accounts for 52% of the Health Care sector. Deciding to 'get exposure' to each sector almost forces you to buy these stocks.

In other sectors, there are too many candidates. The big four banks account for almost 30% of the S&P/ASX 200 index, a massive proportion compared to international markets. Other financials and mining stocks (classified as 'materials') also account for disproportionately large weightings in the Australian sharemarket.

So slavishly following index weightings could cause your portfolio to be poorly diversified. You can have a perfectly sensible portfolio without ever owning certain sectors, even significant ones like banks (whatever your broker says).

So why do investors focus on diversification rather than value? For one thing, the concept of 'don't put all your eggs in one basket' is drummed into us. Brokers and advisers invariably worship at the altar of diversification because it's what they learn themselves.

For another, it's easier. Understanding a business, then valuing it – and the former needs to happen before the latter – isn't easy. It takes time and more than a little effort, but buying underpriced businesses is how you'll produce excellent performance.

So what does it all mean for your portfolio?

First, don't have pre-conceived notions about what your portfolio should look like. If you don't understand or can't value mining stocks, don't buy them. If you decide banks are risky and overpriced, don't buy them either. Intelligent Investor Share Advisor's model Growth portfolio has performed perfectly well in recent years without ever owning a bank or BHP Billiton.

Second, aim to build a portfolio over a period of years rather than weeks. Buying a ready-made five-stock portfolio that your financial advisor – or someone else – has recommended without regard to value violates the most important rule of investing: Never, ever buy a stock unless it is underpriced.

Building a portfolio over time will allow diversification to occur naturally. Different stocks and sectors go in and out of favour, which will present you with buying opportunities. Value the businesses, use any price weakness to buy them, and you'll soon end up with a diversified portfolio.

Finally, although diversification shouldn't be the primary reason to buy, it might inform your decision to sell. Over time, successful investments can become a large proportion of your portfolio (as long-term bank shareholders will attest). Re-allocating capital to other investments – including cash – can reduce your risk of underperformance.

Diversification might be desirable, but let value drive your decision to buy.

Nathan Bell is Research Director of Intelligent Investor Share Advisor (AFSL 282288). To unlock all of Share Advisor's stock research and buy recommendations, take out a 15-day free membership.