The Importance of Diversification in Investing

Seth Klarman, a billionaire hedge fund manager with a phenomenal long-term investing track record with his firm the Baupost Group, recently explained how a successful investor needs to possess contradictory qualities.

One of those qualities is the “conviction to concentrate your portfolio in your very best ideas, and the common sense to nevertheless diversify your holdings,” Klarman wrote. The quote illustrates one of the key challenges facing investors: The need to diversify as well as concentrate their holdings. It’s a fine balance between the two.

I’m not here to point out where the line is. Instead, I want to highlight just how important diversification can be even after an investor has poured in tremendous amounts of due diligence in an investing idea.

My case in point is another billionaire hedge fund manager, Bill Ackman. Ackman’s firm Pershing Square had detailed the extent of its due diligence on the U.S.-based pharmaceutical firm Valeant Pharmaceuticals in an old presentation. According to the presentation, Pershing Square had signed a confidentiality agreement with Valeant in February 2014 which allowed the investing firm to “conduct substantial due diligence” including:

  • Meetings with Valeant’s board of directors in person
  • “Extensive” interviews with management
  • Country-level due diligence
  • A look at Valeant’s research & development pipeline, and more

That’s an incredible amount of homework done and Valeant ended up being roughly a quarter of Pershing Square’s U.S. stock portfolio as of 31 March 2015, according to a regulatory filing.

But even with all the due diligence – and Ackman’s confidence in Valeant – the pharmaceutical company has ended up being a massive disappointment thus far. The stock had lost 29% of its value in the whole of 2015 and is down by 35% year-to-date after accounting issues with the firm were raised, among other problems.

In 2014, Pershing Square had generated a return of 40% which boosted Ackman’s fame. But as a result of Valeant’s collapse, among other factors, those gains have been all but erased.

Ackman’s still a fine investor. According to Fortune, Pershing Square has still managed to generate a strong annual return of 12% for its flagship fund over the last decade. But, Pershing Square’s experience with Valeant is for me, a cautionary tale for the need for investors to think about diversification even after painstaking work and copious amounts of brain-sweat have been expended on an investment idea.

Investors in Singapore don’t need to look too far beyond our shores to appreciate diversification too. There are 54 oil & gas shares listed in Singapore as of November 2014, according to bourse operator Singapore Exchange. From the start of 2015 to yesterday, those 54 companies have seen their shares lose 47% of their value on average. Some particularly horrible examples include the trio of EMAS Offshore Ltd (SGX: UQ4), Linc Energy Ltd (SGX: TI6), and Mermaid Maritime Public Company Limited (SGX: DU4); their shares have declined by at least 64% over the same period.

An investor who had concentrated his or her portfolio in oil & gas stocks would have had an extremely painful time since the start of 2015. In contrast, Singapore’s market barometer, the Straits Times Index (SGX: ^STI), has lost ‘just’ 21% in that timeframe.

A Fool’s take

An overly diversified portfolio can result in an investor merely matching the market’s return. That’s not necessarily a bad thing, but it could be detrimental if the investor’s aim is to earn market-beating returns. At the same time however, it is important that we bear in mind how crucial diversification can be. There are times when even intense research and back-breaking effort can’t save us. Just ask Bill Ackman.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.