One of the classic axioms of investing is diversify, diversify and diversify. It is a practical way of minimizing exposure to the potential downfalls of any single investment. In other words, don’t place all of your eggs in one basket. Most rational investors would agree that diversification is prudent. However, academia has taken this concept so far beyond practicality which leaves many investors a lulled into a false sense of security with hyper-diversified portfolios. I intend for the following four insights to serve as a perspective on a more appropriate level of diversification.
1. The benefits of diversification quickly diminish when adding more than 30 holdings.
To illustrate the benefits of diversification, it is helpful to understand the two primary components of risk. Overall market risks influence stocks indiscriminately and cannot be diversified away with a larger basket of assets. No matter how diversified one is, if economic data sours everything is susceptible to declines. The other type of risk is company-specific risk. This type of risk can be theoretically eliminated by spreading your investment across various companies. Holding two stocks instead of one significantly reduces your company-specific risk. However, 95% of company-specific risk is eliminated by holding a portfolio of 32 stocks (Fisher and Lorie 1970).
2. Over diversification may work against you.
A portfolio comprised of even 100 stocks is spread so thin that the investor can only hope to achieve returns consistent with the broader market. Factor in the costs associated with owning so many securities and your performance returns are reduced. The benefit of reduced risk is too marginal to add any value and it is not very likely to generate alpha (outperformance). A skillful manager should take more concentrated positions in order to strive for the potential benefits of superior stock selection. As someone who has spent the last two decades studying the nuances of finance and stock selection, it pains me to see managers at the helm of strategies comprised of hundreds of stocks. Each company is unique and very few offer a combination of fundamental attributes at a price attractive enough to warrant my investment. To think that someone has found a hundred such examples is asinine and likely means they are a jack of all trades, but a master of none.
3. Only the addition of a superior asset adds value to the portfolio.
This may seem mundane, but it is worth mentioning because too often I am asked why I don’t add physical assets to my portfolio. The message of diversification has become so distorted that many investors find it necessary to add alternative assets to their portfolio. This proposition is ludicrous. Adding an inferior asset for the sake of diversification increases volatility and erodes performance. Certainly there have been isolated periods where the price of gold or collectibles has outpaced the performance of equities and fixed income. Though I am confident this phenomenon is likely to repeat itself, the ability to assess the intrinsic value of such assets and attempt to forecast the future price fluctuations eludes me. There is no skill set I am aware of that reliably values such arbitrary assets. Adding such assets in the name of hedging or diversifying serves only to reduce long term performance with no appreciable reduction in risk. Incorporating an additional component with superior attributes to the portfolio is the only way to add value.
4. If you are going to diversify, then do so.
In addition to adding a superior asset to the mix, one must also ensure the asset is not highly correlated to the portfolio. If the portfolio is highly concentrated in the healthcare sector, adding a pharmaceutical company does not offer the same diversification benefit as adding something from a different sector. Companies within the same industry often face similar risks and therefore the benefit of diversification is limited. The correlation of the asset is inversely related to the reduction in expected volatility. This concept is illustrated in conservative bond portfolios. People are often surprised to find that an allocation of 80/20 (bonds/equities) offers higher returns with less volatility than an allocation of 100% bonds. Because equities have low correlation to bonds and a higher expected return over time, the return for each unit of volatility improves. However, the inverse is not true. A 20/80 (bonds/equities) portfolio will not be superior to a portfolio allocated entirely to equities. The volatility is lower because of the low correlation, but by adding an asset with a lower expected rate of return the entire portfolio will achieve a lower return. To benefit a portfolio, the asset must have a low correlation and a favorable risk to return profile.
In summary, diversification is beneficial and a practical way of reducing risk. However, proper diversification must be done in a way to enhance a portfolio by adding a superior asset with a low correlation. The concept has been so mangled and exaggerated by academics that many investors are unintentionally stifling their performance in pursuit of fallacious risk reduction. Only by deviating from the average can one beat the average. Managers who attempt to beat the market by veering ever so slightly serve only to add additional costs with little additional value. Even if a manager correctly selects a stock that achieves spectacular performance, by allocating 1% of the portfolio to it, they will only enjoy 1% of the benefit. Too often, the fear of underperformance leaves investors hugging the index so closely that any alpha is insufficient to offset the fees. A good portfolio manager will utilize his skill set to invest in a small basket of stocks that he believes will offer superior results.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Stock investing involves risk including loss of principal. There is not assurance any strategy will be successful or protect against loss. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.