Thursday, January 28, 2016

Phil Fisher on diversification

No investment principle is more widely acclaimed than diversification. (Some cynics have hinted that this is because the concept is so simple that even stock brokers can understand it!) Be that as it may, there is very little chance of the average investor being influenced to practice insufficient diversification. The horrors of what can happen to those who “put all their eggs in one basket” are too constantly being expounded.  
Too few people, however, give sufficient thought to the evils of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them. For example, among investors with common stock holdings having a market value of a quarter to a half million dollars, the percentage who own twenty-five or more different stocks is appalling. It is not this number of twenty-five or more which itself is appalling. Rather it is that in the great majority of instances only a small percentage of such holdings is in attractive stocks about which the investor or his advisor has a high degree of knowledge. Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.  
How much diversification is really necessary and how much is dangerous? It is somewhat like infantrymen stacking rifles. A rifleman cannot get as firm a stack by balancing two rifles as he can by using five or six properly placed. However, he can get just as secure a stack with five as he could with fifty. In this matter of diversification, however, there is one big difference between stacking rifles and common stocks. With rifles, the number needed for a firm stack does not usually depend on the kind of rifle used. With stocks, the nature of the stock itself has a tremendous amount to do with the amount of diversification actually needed. 
Some companies, such as most of the major chemical manufacturers, have a considerable degree of diversification within the company itself. While all of their products may be classified as chemicals, many of these chemicals may have most of the attributes found in products from completely different industries. Some may have completely different manufacturing problems. They may be sold against different competition to different types of customers. Furthermore at times when only one type of chemical is involved, the customer group may be such a broad section of industry that a considerable element of internal diversification may still be present.  
The breadth and depth of a company's management personnel—that is, how far a company has progressed away from one-man management—are also important factors in deciding how much diversification protection is intrinsically needed. Finally, holdings in highly cyclical industries—that is, those that fluctuate sharply with changes in the state of the business cycle—also inherently require being balanced by somewhat greater diversification than do shares in lines less subject to this type of intermittent fluctuation.  
This difference between the amount of internal diversification found in stocks makes it impossible to set down hard and fast rules as to the minimum amount of diversification the average investor requires for optimum results. The relationship between the industries involved will also be a factor. For example, an investor with ten stocks in equal amounts, but eight of them bank stocks, may have completely inadequate diversification. In contrast, the same investor with each of his ten stocks in a completely different industry may have far more diversification than he really needs.