Something I have talked about previously are the benefits of diversification. Diversifying your investments reduces overall portfolio risk and volatility. However, the more diversified your portfolio, the more likely it is to reflect the average gains of whatever market you invest in. So how are we to know how many investments form a well diversified portfolio? And are the rewards of a well diversified portfolio worth the effort?
The benefits of diversification:
There are two primary risk of diversification, with the first being the most important.
- Risk Reduction:
- As an investor, you cannot eliminate systematic or market risk, but you can diversify away non-systematic or company-specific risk. It is important to diversify away as much comany-specific risk as possible as finance theory teaches us that this element of risk is not rewarded with extra return. By diversifying your portfolio appropriately, you can reduce the company-specific component of risk without sacrificing your returns, improving your overall investment results
- Capital Preservation:
- In my opinion, the two most important components of an investing strategy is an early start and the ability to stay in the game for as long as possible. The combination of these two factors almost guarantee successful investment results, assuming the strategy you are following is sensible. Unfortunately, if you take too much risk, you may wipe yourself out before your dividend snowball can really get its own momentum. Diversification makes it much easier for investors to remain in the game long enough to benefit from compounding. In addition, investing in a variety of industries makes it unlikely that a portfolio will be unduly exposed to banking crises or tech-mania, for example.
How many stocks do I need to invest in before I am diversified?
In 1970, Lawrence Fisher and James Lorie published a paper in the Journal of Business on the “reduction of return scattering” as a result of the number of stocks in a portfolio. They found that a well-distributed (that is, among different industries) portfolio of 32 stocks reduced the distribution of results by 95% compared to the reference index. This has given rise to the common idea that 30 stocks delivers an acceptable amount of diversification for individuals. Unfortunately, this is a bit of a simplistic measurement of portfolio risk, and subsequent papers have indicated that full diversification requires somewhere in the realm of 50-60 stocks (and possibly up to 100!).
The two charts below help to visualise the tradeoff between portfolio holdings and the risks of the portfolio relative to the broader market.
Again, the key is to diversify away the un-systematic risk associated with a company or industry. With academic research indicating that anywhere between 30-100 stocks is required to minimise un-systematic risk, an individual investor should choose the best balance for themselves between the number of holdings and the diversification benefits. Perhaps most important is to note that stock holdings after 30 or so have diminishing returns in terms of reducing the overall un-systematic risk of the portfolio.
Importantly, the diversification of company specific risk comes at no cost to overall investment returns! You do not increase risk adjusted returns by taking on company specific risk. This is truly the one free lunch in investing.
But Warren Buffett told me I should put all my eggs in a basket, and then watch that basket…
Warren Buffett once said that “Diversification is protection against ignorance. It makes very little sense for those who know what they are doing”. And indeed, the concentrated strategy has payed off for Warren Buffett, but to be clear, Warren Buffett is the greatest investor of our time. Peter Lynch has argued that “the average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration”. Again, to be clear, Peter Lynch may also have been one of the greatest investors of all time (and he also held more than 100 stocks in his public portfolios).
Concentration in a portfolio relies on the ability of the investor to be an excellent business analyst. This includes a deep understanding of both the magnitude and likelihood of the risks of the business. Many famous investors talk about the desire to concentrate their investment portfolios in their best ideas, modelling their behaviour on Warren Buffett. Unfortunately for me, you, and every person invested in these funds, Warren Buffett is very difficult to emulate!
If you think that you are the next Warren Buffett, capable of blending security and business analysis to the point where you can hold just 10 or so stocks and be comfortable with the returns profile of that portfolio, you should of course concentrate your portfolio. There is enough academic research to indicate that a portfolio manager with skill is able to trounce the indices with a concentrated portfolio.
If, on the other hand, you are all too aware of your own failings as an investor (like me!), by far the better course of action is to diversify your portfolio to the point where you have effectively reduced non-systematic risk to zero. In particular, if it is your goal to eventually retire based on your dividend portfolio, you must diversify you sources of dividends so the cutting or ceasing of a dividend from one company does not ruin the income stream from your portfolio. Above, we discussed the need for approximately 30 stocks from different industries to reduce your non-systematic risk to effectively zero; in my experience the more stocks you can identify and monitor, over and above this 30, the better. This increases the defensibility of your dividend stream and trading costs no longer prohibit large numbers of small holdings.
Whats the alternative?
If this number of stocks concerns you (it can be very difficult to keep up with this number of stocks if you do not invest professionally), you should consider investing in Listed Investment Companies, of which I am a huge fan. This provides the required diversification at a low cost. You can even diversify amongst LICs!
Diversification can help an investor manage risk and reduce the volatility of a portfolio. Remember though, that no matter how diversified your portfolio is, market risk can never be eliminated completely. You can and should reduce risk associated with holding individual stocks, but general market risks affect nearly every stock, so it is also important to diversify among industries as well. The key is to balance your ability to monitor your holdings with the diversification benefits; for some investors, this will result in relatively concentrated portfolios, while for other it will result in extremely diversified portfolios.
As an investor, do you prefer concentrated or diversified portfolios? How many stocks do your hold in your portfolio at the moment? Let me know in the comments!