Why Diversify?

You may have heard of the oft repeated advise about not putting all
the eggs in a single basket. It is repeated so often that people want
to rebel against it. But I think diversification is a theory which has
sound mathematical basis.

Assume that you and me decide to gamble on 1 lack rupees on a toss of
a coin. Also assume that you have a special coin which churns out
head 70% of time and tail 30% of time and you have the liberty to pick
up your choice(head or tail). You can also choose how much you would
bet on 1 toss.. i.e that you can toss the coin 1 lack times by betting
1 rupee on each toss or you can put entire 1 lack rupees at stake in 1
toss.

What would be your strategy? How many times would you throw up the
coin? If you had read the chapter on probabilities well, you should
bet 1 lack times on getting head and you have assured chances of
winning approximately 40000 Rs. If you decide to bet 1 lack in a
single toss of coin you may lose up to 1 lack or win 1 lack.

Clearly the choice is yours. In equity investment, there are no risk
free bets just as there are no coins without a flip side.

In such cases diversification increases your probability adjusted returns.

Having said that diversification is necessary but not sufficient
condition to safer returns. This is because if there is any
correlation between returns of the stocks in which you have
diversified you may lose in all of them if things turn worse.

Also there are risk involved in over diversification because of the
transaction costs. Another reason is that it is difficult to find more
than a few stocks where you can get 70% chance of returns. This means
that the more you diversify, the closer you get to average performers.

My personal view is that an equity portfolio having less than 7 stocks
or more than 25 stocks is badly designed.

Posted: July 21, 2005
http://in.groups.yahoo.com/group/lawarrenbuffet/message/1462