Most things in life are good in moderation.
If you eat one pizza, the odds are you’ll enjoy it and won’t feel too bad afterwards. Eat 10 in one sitting and you’ll probably feel much worse.
A similar logic applies to diversifying your investments.
Diversification is something everyone in the investment world seems to agree on and likes talking about, usually with some reference to eggs, baskets, and how you shouldn't put too many of the former into one of the latter.
The reason for this is fairly straightforward. Predicting the future is hard and knowing which companies are going to do well, and which aren’t, isn’t an easy task.
As you’re likely to make some mistakes along the way, having a broader range of companies in your portfolio means the negative impact of any major losses you incur in a single stock is going to be more limited than if you had all your funds in that one firm.
But this has to be balanced against the goal of outperforming the market.
There isn’t much point in buying individual shares if you don’t care about seeing better returns than an index. In fact, it seems much more sensible to just put money into an index-tracking ETF if that’s the case.
Anyone that does want to try and outperform the market will have to deal with the fact that the benefits of diversification are nonlinear.
Imagine having a pile of identical bricks and stacking them, one by one, on top of each other. The total height of the structure will increase at the same rate every time you add a brick.
Conversely, if you eat 10 pizzas, your level of enjoyment will not keep increasing at a constant rate the more you eat. It will probably spike up at the beginning and then trend downwards after you're halfway through your second margherita.
The bricks example is linear. Ten times as many bricks means the structure’s height is 10x what it was before. But eating 10 pizzas won’t make you 10x happier than eating one.
Similarly, if you keep adding stocks to your portfolio, the benefits diversification confers on you are likely to rise at the beginning and then start to level off at a certain point.
Unlike our pizza example, you’re unlikely to be physically ill from buying too many shares. But when you factor in trading costs, the odds are you’ll end up underperforming the market.
That again makes it seem like it’s much simpler, and less time intensive, to just put your money into an ETF.
It also raises the question of what exactly the tipping point is. When does diversification cease being beneficial and start being pointless or even damaging to your returns?
Luckily for us, economist Burton Malkiel looked at this problem a while ago and estimated that by the time you have 20 to 25 stocks in your portfolio, its volatility matches the wider market’s.
That’s not the same thing as saying your returns will match the market’s. What it means is that your holdings are likely to cancel out any overly negative performance, in much the same way an index fund would.
The potential upside is that holding 20 to 25 stocks is still manageable and, assuming you make good choices, could enable you to beat the market.
In short, by that stage you will have achieved as much diversification as you’re likely to get. Adding any more stocks won’t have a huge impact on your portfolio’s volatility and there’s the added chance you introduce assets of a lower quality.
Higher trading costs and having a huge group of stocks to manage means you’ll probably end up seeing a poorer performance than the market.
That’s not to say you should be preparing to go out and buy 20 stocks. Investing in a couple of index-tracking ETFs is a perfectly reasonable thing to do and one that’s produced respectable returns for plenty of investors over the past couple of decades.
It’s more to say that anyone picking lots of stocks and thinking they’ll reduce their risk level by continually adding more is likely to be mistaken.
Doing so could easily harm your returns or put you in a position where you could’ve just replicated an index. Not only does that mean potentially losing money, it’s also likely to be a big waste of time.
It’s been five whole minutes since anyone mentioned growth versus value, we’ve all done well to get this far.
The reality is that, for growth investors trying to identify high quality market leaders, there just aren’t a lot of them. The 20-25 stock range suits that approach because it allows for a concentration of top firms.
As we’ve said, once you go beyond that, chances are you’ll have to add lower quality companies. Diversification is important but so is keeping any rubbish out of your portfolio.
On the other hand, value investors will be constantly stuck in limbo, wondering which of the beaten up, unloved and overlooked firms in their portfolio will rise from the ashes first. And even if that does happen, the nature of value investing means they have to go back out and find another rough diamond
All this uncertainty means value contrarians are likely to hold a lot more stocks than 25. The quality argument is maybe less important because they’re constantly adding seemingly low quality assets to the mix. Whether that proves to be justified or not is their whole raison d’être and the key angle that separates them from their growth-minded cousins.
Whatever camp you fall into, just don’t unknowingly replicate the index and pay for the privilege. Try not to collect companies like football stickers and in the wise words of Peter Lynch, know what you own and know why you own it.
Over diversified or not diversified enough? Let us know on the community forum:
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