What is Diversification, and Am I Diversified?

By: Steve Rubis

A favorite buzz word of finance professionals is diversification. This word seems to be over used in the current financial lexicon. Jim Cramer contends that his game “Am I Diversified: is the latest craze to sweep America. He is right, since he has at least two or three people call in with their portfolios for his review. The problem is that Mr. Cramer is doing a disservice to the novice investors watching his program. His game merely consists of listing the stocks in the caller’s portfolio and then decides almost arbitrarily whether they are diversified or not. It is our contention that the quick and dirty analysis often provided by Mr. Cramer is hardly correct.

First, let us review the rules of the game. There is a particular segment which occurs a few times a week called “Am I diversified”. During the segment, Mr. Cramer takes a few calls and reviews the stocks in each caller’s portfolio. He merely writes down the names and decides whether or not the caller is diversified. Since the decision is made in less than 30 seconds, it can be said that Mr. Cramer bases his decision solely on sector or industry.

The problem is that such advice is financial legerdemain at its best; Mr. Cramer’s statements seem to be more harmful than good. Any finance professional knows that diversification is based on risk. For all novices, there are two types of risk: (1) systematic and (2) unsystematic. Systematic risk is synonymous with the entire market and cannot be eliminated; however, unsystematic risk is the risk associated with a specific stock and can be limited with a well diversified portfolio. The crux of the diversification issue revolves around the CAPM (Capital Asset Pricing Model), since it mathematically assigns risk to every stock using a variable called Beta (Investors can find Betas for most stocks at Yahoo Finance).

At this time we would like to use an example to prove that Mr. Cramer’s analysis is not telling us whether we are diversified or not. Consider the following portfolio: (1) NABI Pharmaceuticals (NABI); (2), Pozen Pharmaceuticals (POZN); (3), Neurocrine Biosciences (NBIX); (4), NPS Pharmaceuticals (NPSP); (5), Jos A. Banks Clothiers (JOSB); (6), Rite Aid (RAD); (7), Grey Wolf (GW). At this time, we assume that our portfolio value is $7,000, with the following dollar amounts:

NABI = $700
POZN = $700
NBIX = $1,000
NPSP = $500
JOSB = $3,000
RAD = $500
GW = $600

In order to determine the riskiness of each position we need to know each stock’s beta, which can be found on Yahoo Finance and are as follows for the sample portfolio:

NABI = 1.05
POZN = -0.49
NBIX = 2.36
NPSP = 1.97
JOSB = 1.12
RAD = 2.69
GW = 1.04

Now we determine the weightings of each stock in our portfolio. The equation is simply:

Dollar Amount for Specific Stock / Total Portfolio Value

Our weights:

NABI = 10%
POZN = 10%
NBIX = 14%
NPSP = 7%
JOSB = 43%
RAD = 7%
GW = 9%

Now to determine the beta for the entire portfolio we multiply the weight of each stock by it’s respective beta. Our portfolio beta and calculation is as follows:

1.05(0.1) + (0.49)(0.1) + 2.36(0.14) + 1.97(0.07) + 1.12(0.43) + 2.69(0.07) + 1.04(0.09)

Which simplifies to:

0.105 + (0.05) + 0.33 + 0.14 + 0.48 + 0.19 + 0.09 = 1.285

The sample portfolio has a beta of 1.285 or approximately 1.29. In reality we have a slightly risky portfolio. The over all stock market has a beta of 1, so any stock or portfolio with a beta higher than 1 moves up or down faster than the market, and if it is less than one moves up or down more slowly than the market.

Our sample portfolio is very interesting because it contains two stocks with betas higher than 2 and one that is negative. If this portfolio was analyzed by Mr. Cramer he would immediately state I am not diversified. The reason for his answer is that the model portfolio has 4 biotech companies, which means we are biotech heavy. Nevertheless, in a mathematical and financial sense we are diversified, because our beta is highly reasonable at 1.29.

Readers should make the following conclusion: diversification should not be based on industry but on the risk of each particular stock in your portfolio. Please note that the sample portfolio beta will change based on our weightings and the respective betas. Nevertheless, our analysis shows that Mr. Cramer needs to go further in his analysis by trying to get a sense of the size of each position in each caller’s portfolio.