How to Diversify Your Portfolio Without Diversification

Diversification is an important element in investing in stocks, mainly to reduce the risk of losses, and in this blog we have discussed the theme of 'diversification' several times, for example in this article, and this. I probably need to say once more that, if you imitate the style of Warren Buffett on diversification, then you can hold about 15 to 20 different stocks in your portfolio. In the 1960s, when still managing Buffett Partnership with funds under management of approximately US$ 40 million, Warren Buffett was only holding about 20 stocks in his portfolio.

The amount of 20 stocks in Warren’s portfolio is much less compared to any other professional fund managers, which they can hold more than 100 different stocks, not including additional diversification by also putting investment in fixed income and money market instruments (eg bank deposits). While Warren, not only he was only put his funds at 20 stocks, but he also likely never put his investment in bonds, and he is rarely holding cash except in small amounts. Therefore, Warren Buffett is known as the anti-diversified equity investor. Currently, Berkshire Hathaway’s portfolio contains more than 100 of different stocks/companies, but it is not because Mr. Buffett has changed his strategy of diversification. But because, with the amount of Berkshires assets that was very, very large (the value of Berkshire's total assets at the end of 2014 was US$ 526 billion), it is unlikely that the assets can be placed on a few stocks only. Let say, if Buffett interested to acquire 100% stake of the largest company in Indonesia, Astra International (ASII), then he only needs to spend around US$ 25 billion, or less than 5% of the whole assets of Berkshire.

However, although Buffett is an anti-diversified investor, but it does not mean that he did not diversify at all. Because as mentioned above, he still puts his investment in about 20 different stocks, not only one or two. Indonesia's most famous investor, Lo Kheng Hong, also accustomed to put his investments in 20 – 30 different stocks.

Based on my experience in providing advice to fellow investors, they sometimes complain that, instead of 20 stocks, their heads are already dizzy when they had to hold 10 different stocks. They usually say things like, ‘Sir, you do not need to give me a lot of stock recommendations. Just give me one or two stocks only, but the best one!' Or, 'From your ten stock-picks, which is the best? I want to buy it only.’

The point is, in the view of some part-time retail investors, what they meant by 'anti diversification' is to focus on one or two stocks only! Because, what is the need to spread your funds on many different stock, if you can put it all on the best ones? Ie stocks which, after analyzed carefully, offering the highest profit potential?

Related to this, I will share about my experience in 2012 ago. In 2012, the property sector on the IDX generally had good fundamentals, so that the stocks in this sector were rising. After selecting the companies, my choices fell on the two stocks that I thought were the best both in terms of fundamentals, valuation, future prospects, and also offering low risk of losses. They were Alam Sutera Realty (ASRI), and Greenwood Sejahtera (GWSA). ASRI was then priced at Rp450’s per share, while GWSA 250’s. In my conservative analysis, I thought that ASRI might go up to 700, while GWSA 400.

Originally I would take both stocks. But because I've already had several holdings in other sectors, I think it would be easier if I take just one. So now I’ve got problem: Which is the best option? Is it ASRI, or GWSA? I eventually took GWSA. As a result, the funds that had been allocated to ASRI and GWSA, all of which are placed on GWSA alone.

Bad luck for me, it was ASRI that successfully go up.. and continue to go up.. until it had hit 1,000! Or gained more than doubled. While GWSA? It only rose slightly to 300, before then turned down around April 2013 due to the company's financial performance that is unexpectedly becomes bad where its profits dropped, because the company is facing a prolonged land dispute that forced them to halt the construction of the building, so that they don’t have any property products to sold. Although I immediately get out from GWSA after I saw the financial statements of the company, but I still suffered losses due to loss of momentum in ASRI. If I diversified my funds where I took ASRI and also GWSA, then I still would gain significant profits, because the gains of ASRI alone were more than doubled (from 450’s to 1,000).

Maybe there is a question: Instead of buying GWSA and ASRI, why do not put all funds on ASRI only? In that way, your profits would be greater, would not it? Yes, it would. But the problem is, how could you tell if it was ASRI that will rise, and it was GWSA that will go down? What if it was ASRI that has force majeure, so its performance fell and thus also its shares, while GWSA had not had any problems so its shares continue to rise? The case of land disputes that hit GWSA above is a force majeure, aka unexpected events that would have a negative impact on the financial performance of the company, and it can occurred to any company whether it GWSA, ASRI, or others.

And no matter how good you are in assessing the fundamentals quality of a stock, but if the company experienced a force majeure, you would still lose! My mistake ain’t because I did not predict that GWSA will have a problem of land disputes, because no one could predict things like that, even Warren Buffett could not. My mistake was this: I did not diversify my portfolio. If I put all funds on ASRI without buying GWSA at all, then it is still a mistake, which although had not resulting in losses (because ASRI rose high), but it will lead to losses in the future.

Therefore, when a friend asked, 'Out of the ten stocks that you recommended, which is the best one? I won’t buy all of them, just the best', I usually replied, 'The ten stocks are the best selections from hundreds of stocks on the Indonesia Stock Exchange. However, one or two of them may still down, either because of force majeure or because I was wrong in its analysis indeed, but I certainly do not know which ones. If I suggest you to buy one stock only, then what if it is the one that causes losses? Therefore, I suggest to diversify by buying all of them.'

The analogy of this diversification is like a math exam. If you have kids who are still attending primary school, then look: Every time he doing a math test, then the amount of given questions are not just one or two, but usually ten. Of the ten questions, if the student is able to answer all of them correctly, then he will get a perfect 100 score.

However, from about forty students in a class, how many students who are able to make a perfect score? At most, only one or two, right? Or even none at all. If a student can make a score of 80 only (from ten given questions, there are two of them that he could not answer correctly), then it is already a good achievement, is not it? It does not matter if there are one or two questions that could not be answered, as long as the other questions can be answered correctly.

Now imagine if the teacher only gives one questions in a math test, so there are only two possible score for students: One hundred aka perfect, or zero aka fail at all. Then how the results would be?

The same thing applies in stock investing. If you buy ten different stocks, then there is usually one, two, or three stocks that turned out to go down, but it's okay. However, if you only buy one stock and it fell down, then your score is zero aka fail at all.

Diversification Technique By Holding One Stock

Unfortunately, even though I had often discussed the topic of diversification like above, but there still many investors who prefer to hold one or two stocks only in their portfolio, and now I can understand it. An investor, if he's not full time in stock, he usually does not put all of his assets in stocks, but also put some of them on the property, mutual funds, etc. This means he has done diversification since the very beginning, so why does he have to diversify further? For a professional fund manager, especially if he manage a large fund and put investment not only in Indonesia but all over the world, then he too usually buy one or two stocks only in Indonesia, because he also has put his investment in stocks in other countries, not including the placement in bonds and money markets.

So the question is, if I still want to put my investment in one stock only, is there any diversification techniques that can be applied? Well, there is! and here is the explanation:

A friend once told me that, in making investment or trading the stocks, over the years he only ever hold one stock, namely Astra International (ASII), and the reason is, ‘I do not want to invest in petty or unknown stocks, so it’s better to play ASII only'. And although ASII itself sometimes rise a lot in a year and then tends to be flat or even down in the next year, but my friend has been successful in making a profit of about 30 or even 40% per annum just by trade the stock.

But how did he do it? Here we go: Whenever ASII down until reached a certain price limit, say Rp7,000 per share, whether it's because of the correction in Jakarta Composite Index (JCI) or for any other cause, he will buy ASII as much as a third of all available funds. If ASII fall further to reach the next price limit, say 6,500, then he would buy it again using another third of available funds (or more, but not all the remaining funds), aka average down, so that the average purchase price becomes 6,750. After that usually ASII will rise to about 7,750 – 8,000, and that’s when he will sell off all the holdings to make a profit of 10 – 15%, including taking into account the remaining funds that were not used.

Furthermore, just wait until ASII down again, while continuing to pay attention to the development of the company's financial statements (so if ASII had a good financial performance, then the price limits can be increased). Except in certain cases where the stock index extremely fell, then ASII usually would not go down further, so that the last remaining funds should not be used (the amount of cash funds is about ten to twenty percent of the value of portfolio, or thirty percent at maximum). But if the JCI experienced a large correction and ASII also fell deeper than usual, say up to 5,000’s, then the remaining funds is always available to use.

So, if he was able to trade ASII as much as two or three times only per year, then the profits are between 20 to 40%, even if the JCI fell deeply like in 2013 ago. And the bonus is, he does not have to worry because he had to pay attention to the movement of one stock, as well as the development of the financial performance of one company only, ie ASII.

Well, got the point? So if you want to invest/trade in one stock only, then you can use this trick: Split your funds into at least three parts (or four, five, six parts, it’s up to you), and then buy your stock gradually using each parts of the funds. In this way, then in case your stock was down further (remember that we can not precisely predict that if a stock is declining, then the decline will stop at what price), you can buy it more at lower prices. If it is still down? Well why, just buy it again! If all the available funds has been used up, then just wait until the stock back to its normal price, aka rise back.

However, this strategy is only effective in stocks with excellent fundamentals and reputation, and they are usually blue chip stocks like ASII, BRI (BBRI), Perusahaan Gas Negara (PGAS), Semen Indonesia (SMGR), and so on. Unless the company exposed to certain negative sentiments, or if the financial performance of the company is slightly less good than usual, then the shares are normally drop only if the JCI fell, and this is totally different from the small stocks that could go down at any time, and the decline can be up to the extreme level, say more than a half of their initial price.

In addition, the risks are still there. If you are stuck in a situation where you put almost all of the available funds in one stock, but then the company experienced a case of force majeure like GWSA above, then your losses would be enormous. Blue chip stocks, although very rarely exposed such force majeure, but it does not mean that they never exposed it. In January 2007, the stock of PGAS had dropped 23% in just one day because of news that the company was delaying its commercialization of one of its pipelines. Several other blue chips such as Berlian Laju Tanker (BLTA) and Bumi Resources (BUMI), their shares even fell to almost zero point without being able to get up again, at least until now.

But obviously, the risk of this 'anti diversification' strategy remains low as long as you keep your focus on the blue chip stocks, and the fact that this strategy proved to be quite successful in some particular investor. So, wanna try?