Most people understand the idea of not putting all your eggs in one basket. Diversification reduces portfolio risk by spreading your money across a number of stocks.
In 1952, Ben Graham wrote about another benefit of diversification that doesn’t get talked about as much:
In this connection I want to throw out a broad and challenging idea — that from a scientific standpoint common stocks as a whole may be regarded as an essentially undervalued security form. This point grows out of the basic difference between individual risk and overall or group risk. People insist on a substantially higher dividend return and a still larger excess in earnings yield for common stocks than for bonds, because the risk of loss in the average single common stock issue is undoubtedly greater than in the average single bond. But the comparison has not been true historically of a diversified group of common stocks, since common stocks as a whole have had a well-defined upward bias or long-term upward movement. This in turn is readily explicable in terms of the country’s growth, plus the steady reinvestment of undistributed profits, plus the strong net inflationary trend since the turn of the century.
Graham likens diversification to fire insurance. He noticed that people paid a higher premium (compared to the actual risk exposure) because they can’t afford to cover the loss of a home without it. In other words, the insurance companies demanded a risk premium of almost twice the actual risk of loss for a single home.
It turns out investors act like insurance companies when dealing with a single stock. They expect a higher premium — via a higher dividend and earnings yield — for the risk they assume in owning one stock.
But it’s not the case when they diversify. It’s as if they expect a lower premium for a basket of stocks because that basket has a (wobbly) long-term upward trend. As Graham points out, the trend is the product of a few things:
- The Fed’s inflation mandate adds a roughly stable increase in asset prices over time.
- Edgar Lawrence Smith’s discovery that stocks have a compounding effect not found in bonds. Basically, when a company consistently reinvests a portion of earnings back into the business, the business grows, and so does the value of the stock.
- A steady growth in a country’s population. Population growth, that leads to GDP growth, will eventually show up in long-run earnings growth.
A diversified portfolio of stocks is helped by the combined effect of all three that show up in long term returns. But that’s hardly guaranteed in a single stock, where a number of other factors are at play that can easily outweigh any long term benefits.
And then there’s the short term, which Graham warned about:
If — as happened in the 1920s — this very thesis is twisted into the slogan that common stocks are attractive investments, regardless of how high they sell, then we would find ourselves beginning as scientists and ending as heedless and ill-starred gamblers. It may be a fair generalization to assert that the top levels of most “normal” bull markets are characterized by a tendency to equate stocks risks with bond risks. These high valuations may indeed have some justification in pure theory, but the important thing for us to bear in mind…is that, when you pay full value for common stocks, you are in great danger of later appearing to have paid too much.
The late 1920s bubble was partially driven by Edgar Lawrence’s Smith’s work, discussed above, on why stocks outperform bonds. Somehow that message got distorted into stocks always outperform bonds. Then price action took over and investors ate it up. In the ensuing collapse, investors quickly realized the excessive risk of paying too high a price.
So if you treat stocks as if risk is nonexistent, like investors did in 1929, the eventual price decline will wipe out any long-run benefit entirely, along with part of your portfolio.
Diversification may offer an added advantage to long term returns but it will never eliminate all risks. A speculative element is ever-present in market prices that must be accounted for in the short term.
Towards a Science of Security Analysis