Here are three solid words of financial advice: ‘Diversify your investments’.
Legendary investor Sir John Templeton coined this succinct quote after he became a billionaire through various investment strategies. He particularly prioritised stocks with low value that Wall Street had neglected. His approach, known as value investing, focused on identifying and investing in undervalued assets with untapped long-term potential before they garnered mainstream attention.
But you don’t need to be a stock sensation to build a sensible, diversified and profitable portfolio. As we said last year, the investment world is increasingly opening up to the non-uber-wealthy. The fact that the investment world is more accessible to those who aren't mega-rich creates a more equitable (and inclusive) playing field.
When investing in stocks and asset classes, a key tool is the company’s financials. The financial statements indicate the company’s stability and liquidity. In turn, financials can guide investors towards the right assets and bonds that meet their financial goals.
Developing a diversified portfolio is a widely accepted investing principle for reducing risk. Yet, not all experts (fully) rally behind it. For example, Warren Buffett suggests that ‘Diversification is protection against ignorance. It makes little sense if you know what you’re doing’.
Mark LaMonica of Morningstar Australia notes that Buffett is not referring to all diversification strategies. In fact, it would be somewhat intuitive if he did, considering that Buffett’s company, Berkshire Hathaway, has stocks in both publicly traded companies while owning 72 companies outright. In other words, Buffett’s portfolio is more diversified than his stock holdings would indicate.
Whilst Buffett esteems value investing above diversification, even he acknowledges the benefits of diversification for the everyday investor – namely its ability to help manage (and reduce) risk.
The opposite of diversification, concentration (which amplifies exposure to a smaller number of investments), is only viable (strategy-wise) when the individual owns or controls the companies/investments. The individual can then influence the management decisions in the company and avoid any risks that could compromise profitability.
In other words, when accompanied by company ownership, concentrated investments could, in theory, pay higher dividends than diversification. Of course, the average player in the newly equitable investing world will unlikely own the companies. Therefore, diversification is still a vital strategy for managing risk for the non-Buffetts of the world.
In Buffett’s 1993 annual letter to his shareholders, he qualifies ‘diversification’ as conventional diversification (i.e. spreading investments across multiple assets as it is the ‘done’ practice). Where diversification meets delusion is where diversification compensates for an investor not understanding their investments (i.e. the risks involved, the valuation metrics, the macroeconomic influences, etc.). Investors may be deluding themselves into a false sense of security rather than relying on informed decisions.
Not everyone can succeed from John Templeton’s strategy of buying 100 shares of every NYSE-listed company trading below $1 per share. Following what is conventional can, therefore, be financially detrimental. In other words, diversification for the sake of diversification is delusion.
One way to understand the best investment approach for you is to go back to the tried-and-tested – thorough financial analysis to determine the minutiae of a company’s investment potential.
Fundamental analysis quickly converts financial statements into actionable insights about a security’s intrinsic or true value. The financial statement is a key part of the puzzle, though its information may need to be supplemented with qualitative insights about the company’s competitors, management and economic indicators. Here’s how you can use financials in fundamental analysis:
Qualitative and quantitative analyses are another way to break down a fundamental analysis. The financial statements and the calculated financial ratios form the foundation of the quantitative analysis. Whereas, the qualitative analysis considers competitive positioning, brand reputation and management quality.
Ultimately, the fundamental analysis aids portfolio diversification by:
Informing your diversification banishes delusion and builds wealth. It’s that simple.
Diversification is a necessary strategy for managing risks and preventing losses for most investors. One of the main misconceptions of diversification is that it can compensate for a lack of financial literacy.
To understand the best investment strategy, some investors may choose to complete a fundamental analysis of a company’s securities. Underpinning the fundamental analysis are the financial statements. Of course, if analysing every prospective firm’s financials seems daunting (and ultimately time-consuming), consider leveraging AI to expedite the process.
Financial Statements AI is a specialised solution for converting financial statement PDFs into Excel files containing the extracted and structured financial data. Though Financial Statements AI cannot conduct a fundamental analysis, it prepares the necessary data.
Think of it like the financial version of a meal prep kit. Though it won’t cook the meal (or complete the financial analysis for you), it provides you with the essentials while saving you the tedious shopping trip (i.e. collating the financial data).
Try it today for free – book a demo or email our team at hello@evolution.ai.
