On Diversification

Diversification is not an easy subject, but by analyzing data and applying some logic you can narrow down an optimal strategy

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Chris Gilbert
Apr 25, 2016
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On DiversificationThe age-old question of exactly how many stocks to hold is likely never going to be definitively answered. There are entire books, even courses, on the subject after all. Since portfolio construction is more of an art than a science, in this post I want to break down relevant studies, examine historical data and analyze some of the best investors in an attempt to come up with the optimal strategy. As always, please share your comments and thoughts below!

Talking points

  • Diversification by the numbers.
  • Myths of diversification.
  • Why are you investing in individual stocks?
Wide diversification is only required when investors do not understand what they are doing. Warren Buffett (Trades,Portfolio)

By the numbers

My investing strategy, which is definitely not perfect, consists of holding relatively few stocks (around 10 or so). This is because I want to invest in wonderful companies purchased at attractive prices. I have found that these opportunities, especially of late, don't seem to come around all that frequently. This also makes me a big believer in holding a decent amount of cash in my portfolio as well. But why adopt this strategy?

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It's simple logic: The more stocks you own, or the more diversified you are, the less likely you are to underperform the market. By this same logic, however, you're also much less likely to outperform the market. Say you own two stocks and one doubles while the other stays flat. You still earn a 50% return. With four stocks and one doubling a 25% return. What about more? Say you own 10 stocks and one doubles while the others go nowhere. You'd still earn 10%. Twenty stocks, 5%. One hundred stocks, 1%. While this may be an oversimplified example, you get the point. The more stocks you own the more your results trend toward average.

But let's look at some more numbers. In the book "Investment Analysis and Portfolio Management," Frank Reilly reviewed studies regarding randomly selected stocks and found that as few as 12 stocks could attain around 90% of the maximum benefits of diversification. He also goes on to note, if the individual investor is properly diversified 18 or more stocks = full diversification according to his research then the investor will average market performance. According to Reilly the only way to beat the market is by being less than fully diversified.

In his book, "You Can be a Stock Market Genius,"

Joel Greenblatt (Trades, Portfolio) came to a similar conclusion. Greenblatt found statistics that showed owning only two stocks can eliminate 46% of nonmarket risk. This number climbs to 72% with four stocks, 81% with five stocks and 93% with a 16-stock portfolio. As you can see, the amount of nonmarket risk decreases the more stocks you own, which was already obvious. But let's keep going. You would need to own 32 stocks to eliminate 96% of nonmarket risk and a whopping 500 stocks to almost eradicate it (99%). Greenblatt's point is there seems to be a pattern of diminishing returns after a certain number of stocks. Personally, I would argue maximum benefit is to be had between eight and 16 stocks.

Myths of diversification

Myth No. 1 You can diversify away risk

One of the main reasons investors are afraid to concentrate their portfolios is the belief that it's too risky. While it may be true to a point, can you ever totally remove risk? We've already seen you can partially remove nonmarket risk, also known as unsystematic risk, by holding more stocks. But systematic risk is a different animal. This type of risk cannot be diversified away. Consider all of the factors that affect the stock market such as macroeconomics, irrationality or interest rates. You'll never be able to remove these elements from the equation if you own 1,000 stocks. Think of systematic risk as the inherent risk of investing in stocks.

Myth No. 2 Overdiversification is safer

So what, you say. It still seems safer to own 100 stocks compared to 10. But is it? While you may dilute your unsystematic risk, how much do you really know about your portfolio? Would you even know which stocks you own? Maybe you invest in index funds, which is totally fine for some by the way (more on that later), but if you're an individual investor and you own 40-plus stocks there is no way to know the ins and outs of every one. We'll call this practical risk. Practical risk means you may lose your main advantage in the stock market, competitive insight. When you overdiversify, you may miss out on a great opportunity and be saddled with a regrettable investment because your focus is stretched too thin.

Myth No. 3 Diversification can increase success

I've already explained two reasons why this is a myth. The more you stocks you hold, or the more diversified you are, the more your results trend toward average. This inherently decreases success, unless you want average. Second, when you own too many stocks, practical risk increases. Overdiversification makes it very difficult to invest in wide-moat, wonderful companies. There simply aren't that many great opportunities available at any given time. This also decreases chances of success. Last, when you begin to invest in many different stocks just to increase diversification, you increase portfolio turnover. This inevitably leads to more fees and commissions, which also puts a damper on potential success.

We believe that almost all really good investment records will involve relatively little diversification. The basic idea that it was hard to find good investments and that you wanted to be in good investments, and therefore, youd just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, its proven to be an obviously good idea. Yet 98% of the investing world doesnt follow it. Thats been good for us. Charlie Munger (Trades,Portfolio)

Why are you investing in individual stocks?

We've seen the more stocks you hold, the less chance you have of underperforming the market. This also means the less chance you have of outperforming the market as well. By this logic, the only way to increase our chances of success is to hold fewer stocks than a completely diversified portfolio. By doing this we take on the inherent risk of owning stocks, so the real question to ask yourself is why are you investing in individual stocks?

If you want to have a better performance than the crowd, you must do things differently from the crowd. John Templeton

If your answer is to invest your money in a proven vehicle that, historically speaking, beats all other investment options, and you don't want to take the time and effort to perform proper fundamental analysis on each and every one of your stocks, then I would recommend an index fund. I mean let's face it, we're not all Buffettor Peter Lynch, and we're not likely to be. But there is still no situation in which I would ever recommend going out and buying 50 some odd stocks just to say you're diversified.

As we just talked about, this can actually increase risk and reduce your chances of success in a variety of ways. Index funds, on the other hand, are a great way to expose yourself to the stock market and are likely to beat every fund manager over the long haul anyway.

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Now, if your answer is you think you can beat the market, then I recommend you keep a fairly concentrated portfolio of eight to 12 stocks. Why eight to 12? Well, for one, you don't want to be too diversified for all the reasons stated above. And second, we've seen you can only diversify so much before the benefits begin to severely drop off. Last, if you're really practicing a true value investing strategy, it's unlikely you're going to find an abundance of opportunities out there. To mitigate risk, search out high-quality companies with a competitive advantage and purchase when they're selling at a discount to their intrinsic value. By concentrating your portfolio, you can obtain a thorough understanding of each company and, coupled with a value investing strategy, decrease risk while increasing returns.

Summary

  • Strictly reviewing the numbers, it makes little sense to overdiversify your portfolio.
  • Overdiversifying will not eliminate all risk nor increase your chances of success.
  • If you are willing to practice a value investing strategy and research each of your investments, then focus your portfolio to eight to 12 stocks.
  • If not, invest in an index fund.
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I am a full-time pharmacist as well as an avid investor. I discovered the art of value investing by reading the works of Benjamin Graham. After that I began to drift towards Peter Lynch, Warren Buffett, and Charlie Munger. My investing philosophy now is simply to find great companies at a discount while using a common sense, value oriented strategy, and maintaining a long-term outlook. I am determined to educate the individual investor that investing is not hard, not time consuming, and not expensive. Through the use of value investing and the YourPortfolio Software, my goal is to help you obtain better results in a fraction of the time.