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My 2019 Investment Lessons - Diversification

Time flies. 2019 is about to end and 2020 is just around the corner. This year is yet another fun and challenging year for investors. Opposite to the consensus view at the start of the year, major economies across the globe have re-started quantitative easing; and widening wealth gap and income inequality have created more social unrest and anti-establishment movements, as seen in many parts of the world, represented by the ongoing social disruption in Hong Kong.


The coming posts are investment lessons learnt by me in 2019, through both successes and failures. The purpose of this writing is foremost to help myself to reflect on the decisions made throughout the year and possibly to extract and condense those experiences into rules and principles that will help me to be a wiser investor in 2020 and beyond.


Lesson 1: Diversification and Proper Bet Size

Every professional investor knows the importance of diversification, or at least they think so. However, in nowadays investment management industry, the concept of active shares often trumps the old idea of diversification. Apparently, betting one stock which goes up 70% in a year is much sexier than a well-diversified portfolio which delivers a return of 30%. And it for sure makes one feel much more special when bragging about it to peers.


My lesson about diversification in 2019 is that a healthy degree of portfolio diversification offers greater room for investment errors. This essentially makes the portfolio more resilient and exist for a more sustainable period of time. Investment errors go beyond (simple) real numerical errors in the underlying valuation process, which of course should be avoided at all cost. It could be a timing mismatch, meaning the market has not yet recognised the value offered by a stock, which may eventually outperform the market in 6 months or 3 years. It could also be a tail risk becoming true, be it management misconduct or an outbreak of month-long social unrest.


Yet, forming a truly well-diversified portfolio is difficult, as it demands more than just professional knowledge and experience - it certainly requires more efforts and hard work; but mostly importantly, it demands courage and humility, to admit the fact that we are just human. It is difficult to admit one’s weaknesses and limits, and for professionals such as myself, you need to time that difficulty by 10X. There is no explanation for that, just human nature.


The truth, however, is that whoever you are, whatever you try or however long you persist, you cannot know everything. We are just marginally smarter than apes and accept it or not, most of the things that happen are out of our control. This is hard to swallow, but it is the bitter truth. Once you see and accept it, you will also see the silver lining out of all these - that by hard work, we can be better than an average investor in the market - and that is all you need. If we have a 55% winning rate, we may loss in the 1st round, the 2nd or even the 3rd; but eventually, statistics will work and we will win in the long run. The key here is the ability to play in the long run, and diversification enables you to do that.


Another benefit of diversification is related to bet sizing. Over the course of a year, the typical scenario for a well-diversified portfolio is that some holdings outperform while others underperform. Apart from regular portfolio rebalancing, diversification offers the room to tactically relocate some weight from the outperforming names to the underperforming ones whereas a concentrated portfolio leaves limited room for that manoeuvre. This is driven by probability.


Think about two portfolios - Portfolio A holding 10 names and Portfolio B holding 3 names. Further assume that through diligence and experience, we have a winning odd of 55%, meaning 55% chance of a name outperforming the market and 45% chance of underperforming. Now let’s calculate the probability of the event where all the names in the portfolio underperform the market (for simplicity, assuming each name’s result is independent of each other). Here are the results - 0.03% for Portfolio A and 9.11% for Portfolio B! Compared to Portfolio A, Portfolio B has a whooping 303 times greater risk of all of its names underperforming the market. Once all the names underperform, it is hard to reposition and get out of the hole.


To sum up, making investment mistakes is inevitable and to admit that requires courage and humility. Diversification lowers the cost of those errors and enables us to last longer and win in the long run.

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