Blog 5 - The True Magic of Diversification

Hidden within every portfolio are multiple levers to actively shape its performance character. Performance, risk, and volatility profiles can all be favorably improved through strategic diversification across five dimensions:

1. Asset Type (Stocks, Bonds, Cash)

2. Economic Sector (11 macro categories)

3. Industry (69 categories)

4. Geographic Revenue Sources

5. Market Capitalization (Small, Medium, Large, Mega)

Optimal Number: 25-30 Stocks

Imagine owning just one stock. Adding a second would reduce business-specific risk. But what about adding 99 more stocks? At some point, you're essentially replicating a market index but with the added administrative burden of tracking and periodically adjusting every position.

According to Figure 1, the ideal number for active investors to maximally reduce "Diversifiable Risk" is approximately 25-30 stocks—as long as they're relatively uncorrelated.

Figure 1 Source: Easy Portfolio

"Diversifiable risks are more easily discerned during each reporting season when corporations bare their financial soul."

Diversifiable risk represents unique operational hazards—fraud, obsolescence, legal issues, supply chain disruptions. This differs from systemic risk (general market volatility). Quality assets and larger market caps tend to incur fewer operational surprises and lower overall volatility.

Diversification by Economic Sector

Globally, all businesses fall into 11 economic sectors and 69 industry categories. Nine sectors create economic value through strategic advantages; two (Materials and Energy) are commodity price-takers where timing matters most.

Rather than attempting to predict which sectors will outperform, consider mimicking the sector allocations of the S&P 500 or MSCI World Index (Figure 2). This approach:

• Simplifies portfolio management

• Generates performance relative to the broader economy

• Reduces the temptation to play "sector rotation bingo"

Figure 2 Source: SP Global

Compounding businesses exist even in defensive sectors like Utilities, Healthcare, and Consumer Staples. Allocating proportionately across 9 of 11 sectors allows you to focus on more effective value-creating activities: periodic rebalancing, covered calls, cash-secured puts, and portfolio insurance (Tiers 2-4 in The Investing Oasis).

Diversification by Industry: Where the Real Magic Happens

"Covariance is the secret ingredient."

With 69 global industry categories, avoiding duplication should be straightforward in a 20-35 stock portfolio. Yet familiarity breeds complacency—investors often cluster holdings in industries they know well. This becomes painful when markets decline and highly correlated positions move in lockstep.

The Free Lunch Revealed

Consider this example (Figure 3):

Figure 3

Stock 1: MSCI Inc (Financial Services)

• 5-year return: 31% | Standard deviation: ±30%

Stock 2: ServiceNow (Tech Software)

• 5-year return: 32% | Standard deviation: ±31%

Combined, you'd expect the two-stock portfolio to maintain ~31% returns with ~30% volatility. Instead, the combined standard deviation drops to ±27%. Why? Their covariance is only 0.62—they don't move in perfect tandem.

Stock 3: Apple

• 5-year return: 39% | Standard deviation: ±30%

The three-stock portfolio delivers 33% average returns with just ±25% volatility. Businesses from different industries with low covariance create this mathematical advantage.

"The challenge is to find these compounding stocks and then piece them into a cogently designed portfolio with low covariance pairings."

Practical application: Stock pairings with correlations above +0.6 offer minimal diversification benefit (Figure 4). Example: Mastercard and Visa have a 5-year correlation of 0.93. Well-diversified growth portfolios typically show correlations between +0.4 and +0.6.

Use the Portfolio Analyzer Platform to assess correlation coefficients for up to 50 stocks. Sometimes a high-performing stock isn't the best addition if it undermines diversification.

Figure 4

Geographic Revenue Diversification

Over 50 years, the world has shrunk. Investors can now achieve global exposure through quality North American stocks with international brands (Figure 5).

            Figure 5 Source: Visual Capitalist

This approach:

• Simplifies the investing experience

• Offloads foreign regulatory and legal risks to corporations

• Provides surprising geographic dispersion

The Oasis Growth Fund invests entirely in North America (70% US / 30% Canada), yet revenues are globally dispersed (Figure 6). Why complicate matters investing directly in foreign exchanges when North American multinationals handle those complexities?

Figure 6 Source: OGF Data - June 30, 2025

Market Capitalization: The Small-Cap Opportunity

Large-cap stocks offer stability and lower volatility. Small and mid-cap stocks ("smid-caps") provide performance dynamism—but with higher volatility.

"If selection criteria naturally weans out most small-cap stocks, when could they ever be worthy additions?"

Answer: When a smid-cap's Sharpe Ratio¹ exceeds your portfolio's ratio and shows low covariance with existing holdings.

Real Example (Figure 7)

Figure 7

Starting with our 3-stock portfolio (33% returns, ±25% volatility), we evaluate two small-caps:

Century Communities (CCS) - Real Estate

• 5-year return: 40% | Volatility: ±53% | Average covariance: 0.38

• Result: Portfolio returns rise to 35%, but volatility increases to ±29%

Hammond Power Solutions (HPS-A) - Electrical Engineering

• 5-year return: 42% | Volatility: ±43% | Average covariance: 0.23

• Result: Portfolio returns jump to 42%, while volatility decreases to ±24%

Despite HPS-A's high individual volatility, its exceptionally low covariance with the existing portfolio improves both performance and volatility metrics. This is a real deployment by the Oasis Growth Fund.

Lesson: Higher-volatility stocks can still enhance portfolio characteristics through superior diversification benefits.

Summary

While the absence of planned diversification doesn't doom a portfolio, being diversification-smart can improve performance, reduce undue risks, and diminish overall volatility.

Additional refinement opportunities exist through business model selection (SaaS, B2B, B2C) or target market strategies (luxury vs. high-turnover models).

Since market calm is the exception, conscious diversification is the second step toward preparing for inevitable storms. The first is to buy quality assets.

Portfolio protection strategies will be explored in a future blog.

Resources:

• Portfolio Analyzer Platform – Assess volatility metrics and correlations

• The Investing Oasis - Chapter 11: "3+ Degrees of Diversification"

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

_________________________

The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.

[1] Sharpe Ratio = Stock performance less Risk-free Rate (T-bills) divided by a stock’s Standard Deviation