Diversification is one of the most important tenets to successful investing. Simply put, diversification is the idea of spreading your total investment dollars among different investments so that you “don’t put all your eggs in one basket.” The idea behind diversification is to make sure no single investment or small group of investments can irreparably damage your financial situation. Also, diversification is designed to reduce overall volatility, as different investments may not have the same characteristics; therefore some investments might be acting well, while others go through a lackluster period, ensuring that at least some part of the overall portfolio is doing well at all times.
By convention, many investment managers will implement diversification by spreading investment dollars among many different securities, and by making sure a certain portion of the portfolio is invested in different industries and market segments. Often, the allocation among different sectors etc. closely tracks the benchmarks or market indices against which the investment managers are measured. While conventional and popular, this type of approach in our view is more suited to reduce tracking error from the relevant benchmarks than designed to produce the appropriate balance between risk and reward for clients.
Here at PDV, we practice diversification differently. Instead of following some rigid formula as to how many investments we should buy in each industry or market segment etc., we diversify by endeavoring to apply our value-driven investment approach consistently over a portfolio of investments, all possessing financial characteristics that appear to tilt the odds of success in our clients’ favor. The idea is that though any one situation with favorable odds may not ultimately work out, a portfolio of securities all seemingly with favorable odds will statistically yield enough winners to generate satisfactory results for the entire portfolio. At times, this means clients may own a lot of investments in one particular area of the market, sector or industry that has been particularly out of favor, thereby offering the greatest number of undervalued opportunities. Under these circumstances, clients’ investments may at times be more concentrated in any one market segment or industry than typically would exist in other diversified portfolios, at least as defined under the conventional method of diversification practiced by most other investment professionals.
There are other ways we think about diversification. Unless the client desires an all-stock portfolio, we also use asset allocation techniques to achieve diversification by spreading investment dollars among cash/cash equivalents, fixed-income and stock investments. These asset classes tend to move in different directions from time to time and possess different risk characteristics.
Another way we diversify is by assembling client portfolios, one investment at a time, based on a company’s operating and investment characteristics. So, for example, steady growth stocks like pharmaceutical companies tend to do better during recessionary times, while cyclical growth stocks like technology companies might do better coming out of a business recession. On the other hand, the progress of special turnaround situations would depend on developments specific to those companies, independent of the business cycle. Assembling a portfolio of investments with these different attributes will generally result in certain investments “zigging” while others are “zagging,” increasing the odds that at least part of the portfolio might do well at all times.
Finally, we also endeavor to achieve diversification for our clients by constructing portfolios with investments possessing different risk/reward profiles. Some are higher risk/higher reward opportunities, while others have lower risk/lower reward qualities. We try to select investments for you that fall within the entire risk/reward spectrum, which together are intended to produce the appropriate risk/reward profile for the entire portfolio.