Philip Fisher Articles: Over-Diversification

Posted on Wallstraits.

---------

PHILIP FISHER ON OVER-DIVERSIFICATION

Everyone is aware of the horrors of putting too many eggs into one basket. Few people consider the 'evils' of the other extreme-- 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.

Philip Fisher regarded it as appalling that investors were persuaded to spread their funds between 25 or more stocks. The investor, or his adviser, is highly likely to be placing money in companies of which they know little. The result is that only a small proportion of the money is left for placement in companies of which they have a thorough understanding. As Fisher said, 'It never seems to occur to them, much less to their advisers, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.'

Fisher draws an analogy with an infantryman stacking rifles to illustrate the degree of diversification needed. The 'stack' would be unstable with just two rifles. Five or six, properly placed, would be much firmer. 'However, he can get just as secure a stack with five as he could with fifty.' The analogy is inadequate in one respect: the number needed for a stack does not depend on the type of rifles, but the number of stocks needed for adequate diversification does depend on the nature of the stocks in the portfolio.

For example, some chemical firms have a considerable degree of diversification within them-- serving different markets, industries and consumers. Another risk reducing factor is the extent to which the companies are run by a broadly based management team rather than a one-man management. Investing in a number of cyclical industry stocks will need to be balanced by investing a reasonably large proportion of the fund in stocks less subject to fluctuation. It would be unwise to invest a high proportion of the fund in stocks belonging to one industry, say bank stocks. On the other hand an investor who splits the fund equally between ten stocks in ten different industries may be over-diversified.

Fisher suggested that if the investor was focused on large well-entrenched growth stocks then the minimum degree of diversification should be five such stocks-- with no more than 20% in each. Also, there should be very little product line overlapping. If the focus is on companies that are more established than start-up technology stocks, but are not yet leading and well-entrenched growth stocks, then the investor should not put more than 8-10% of the fund in each. The final category is small companies, 'with staggering possibilities of gain for the successful, but complete or almost complete loss of investment for the unsuccessful.' Never put more money into these than you can afford to lose and never put more than 5% of the fund into one stock.

Investors should only add more securities to their portfolio if they can keep track of all the company events, strategic conditions, management quality and a host of other factors about each company. As Fisher puts it...

Practical investors usually learn their problem is finding enough outstanding investments, rather than choosing among too many... Usually a very long list of securities is not a sign of the brilliant investor, but one who is unsure of himself. If the investor owns stock in so many companies that he cannot keep in touch with their management directly or indirectly, he is rather sure to end up in worse shape than if he had owned stocks in too few companies. An investor should always realize that some mistakes are going to be made and will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Credits: Much of this article is extracted from Valuegrowth Investing by Glen Arnold, Chapter 5: Philip Fisher's bonanza investing.

------------------

Previous Philip Fisher articles

1. Philip Fisher Articles: Finding Growth Stock
2. Philip Fisher Articles: Investing in Growth
3. Philip Fisher Articles: Conservative Investors Sleep Well
4. Philip Fisher Articles: Switching Stocks
5. Philip Fisher: 15 Checklist When Buying A Stock
8. Philip Fisher: 10 Commandments That An Investor Must Not Do