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Clear Thoughts
Portfolio Diversification
Originally Published Friday, January 28, 2005
| Portfolio diversification is crucial in achieving consistent, superior performance above the benchmark without excessive risk. How are our portfolios diversified? |
We hear a lot about the need for portfolio diversification in the financial press. It is praised as a concept by academics, journalists, and seemingly everyone else in the investing community. Conceptually, the idea behind diversification in the world of stocks is that by combining the risk and return characteristics of multiple securities, one can attain a superior result than is possible with any one investment. By adding incrementally more stocks to the available investing universe, the potential risk-reward tradeoffs become more and more favorable.
Here at Clear Asset Management, we agree that diversification is important. However, as one looks over our portfolios, it is evident that we sometimes are holding multiple stocks from the same industry. Hence, an investor may wonder just how diversified we are. After all, there are many pundits who argue that holding positions that are concentrated in any given area is a mistake.
Does this mean that our portfolios are excessively risky? We do not think so. The latest academic research suggests that a universe of ten stocks can be arranged to generate a portfolio with nearly the identical risk and reward tradeoffs as a universe of 500 stocks can offer. This is because as one adds incrementally more companies to the investing universe, the benefit for the risk-reward tradeoff diminishes. Based on this thesis, we think with our portfolios of 20 or 25 stocks in total, we have created ample diversification.
When it comes to choosing which industries and stocks are represented, we leave it to our computers to choose the best available opportunities, period. And sometimes that means that some of the best opportunities are concentrated within a given industry. Based on our rigorous testing of our computer-driven investment models, we believe that, even though our portfolios sometimes are concentrated in certain industries, we have found a system for outperforming the market's returns.
That brings us to an important point: our goal as investment managers is to beat the relevant benchmark in each of our six stock portfolios in long run. To generate market-beating returns, one has to have a portfolio that does not look identically like the market. Otherwise, at best, one can mimic the market's returns, and at worst, one will certainly lag the market after accounting for fees. Holding a portfolio of hundreds of stocks, like many in the mutual fund business do, is a nearly sure-fire way to ensure that one cannot beat the market. Once fees have been taken into consideration, the task is nearly impossible.
As of yesterday's close, the Clear portfolios to date, in aggregate, are handily besting the market's returns. Since inception our stocks have returned 9.89%, versus the benchmark S&P 1500 Composite Index return of 4.99%. And we think results like these are aided in no small part by having portfolios that are not identical to the market. We believe that these results are a very promising beginning. We recognize that we have been investing money for just over four months now, and that the long term results must bear out our philosophy. Based on our testing results, academic research, and live money results to date, we think we have found the right combination of computerized models and diversification to accomplish our goal of long-term market out-performance.
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