Is Your Portfolio Dangerously Diversified?

When I was a kid, Halloween served one purpose — to collect as much candy, in as little of time, as possible.

My costume was designed to provide mobility and minimal obstruction. More importantly, my candy bag (also called a pillow case) was built to transport the haul I planned on collecting. Come sundown, I was off filling my bag with anything the homeowners were willing to give.

At the end of the night, I’d have a stockpile larger than I knew what to do with. However, unlike most other kids, I never ate much candy in the following weeks. Not only did I not enjoy the sweet taste, I wanted to keep a memento of all my hard work. Come the summer months, my stash had lost its appeal and my mom would eventually throw out the stale candy.

Yes, I understand my trick-or-treating methods are odd and don’t make much sense. Nevertheless, it has a strong similarity to the approach many people take when building a portfolio of stocks.

They pack their pillow case with hundreds of companies in an attempt to diversify. Once complete, it appears they possess an appealing stockpile with nothing but potential. As the weeks pass, they are left with a memento of hard work, sitting in their closet, doing nothing useful.

My Halloween diversification is only a harmless and comical memory. However, the misled investor’s diversification will end up being a lifeless and unrewarding disaster.

You’ve probably already heard something about the importance of diversification in stocks. However, before you act on that, it is important to understand what it really means to diversify a stock portfolio.

It Helps to be Different

The imaginary investor described above simply believes diversification is achieved when you own an abundance of stocks. This is a popular understanding among many of us — both amateur and professional. Did you know the average mutual fund holds around 90 different companies?

It all started with the introduction and practice of Modern Portfolio Theory. The theory claimed to have found a correlation between risk and a portfolio’s volatility. If your holdings collectively reach higher highs and lower lows than the market, it is considered riskier. So according to the theory, to have a protected portfolio, we must hold a similar amount of stocks as the market.

Although it is now proven that there is no correlation between risk and portfolio volatility, the practice is still being used. Just look at all the mutual fund managers that use investors’ money to diversify incorrectly.

Following Modern Portfolio Theory and modeling the market is a dangerous practice. Consider the following chart:

This simple table demonstrates the pitfall of over diversifying: it will hinder our returns. The 7% highlighted in red represents the average return on the S&P 500. Assuming the index continues to grow at that rate, a $10,000 investment becomes $19,672 after 10 years. Not horrible, but if we only increase our return by 3% our initial investment is now worth $25,937. Let’s take it a step further: If we double the market and return 14%, we can withdraw $37,072 in a decade. I know I could find a use for the extra cash!

In order to create returns greater than 7% and beat the market, we must be different than the market. To be different than the market, we must not pack a portfolio with a small amount of stocks.

Diversification is Our Greatest Defense

When investing, we are all susceptible to two different types of risk — systematic and unsystematic. The former is also called market risk while the latter is also called nonmarket risk.

Unfortunately, there is hardly any defense against market risk. It is the unpredictable movement of the overall market. As much as some people believe they can predict the future, they are wrong. It is impossible to adjust our portfolio to perfectly defend against market uncertainty.

With that said, we can defend against nonmarket risk. How do we go about doing that? The simple answer is we need to diversify. Although, as we have already found out, that nine letter word can mean different things to many people.

Followers of Modern Portfolio Theory would tell you that unsystematic risk is only eliminated once we own the same amount of stocks as the market. However, studies have found this to be extremely inaccurate. Well-known value investor Joel Greenblatt mentioned this discovery in his book You Can Be a Stock Market Genius.

Believe it or not, nonmarket risk is eliminated by 46% with a portfolio of only two stocks. Continuing on, it’s eliminated by 72% with four, 81% with eight, 93% with 16, and 96% with 32. Lastly, a portfolio of 500 stocks eliminates 99% of nonmarket risk. As you can see, there is not much extra value gained from holding 500 compared to 32.

Our results have found the perfect size of portfolio is achieved somewhere between 20 to 30 holdings. For a final word on diversification and risk, I turn it over to none other than Warren Buffett:

The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Now that we know the perfect portfolio size, there is more to think about. It would be unwise to buy 20-30 different stocks and call it diversified. That is something our imaginary investor would do. We are smarter than him and should put more thought into each holding.

Industry to Industry

The first thing to consider is diversifying across industries. The markets are divided into different categories; some of them being cyclical in nature. A portfolio of 23 airline companies is not diversified. When people have lots of money to spend on travel, the holdings would excel. However, once that money is gone, they would suffer. Whenever possible, try purchasing a portfolio with holdings that will balance each other out. When one goes down, another goes up.

There are also non-cyclical industries that work well in a portfolio. Take a look around your house and find products that you never seem to have a shortage of, and even when you do run low, it becomes a priority to restock. For me, these would be toothpaste, salt, dish soap, cereal, shampoo, and peanut butter. The companies that make these products are examples of non-cyclical industries.

A good balance of cyclical and non-cyclical creates a portfolio that is well diversified across industries.

One Size Does Not Fit All

The market is also divided into categories based on market capitalization. These include large cap, medium cap, small cap, and even micro cap. A large cap is going to perform differently than a large cap. A company worth more than $10 billion will be more stable but take longer to appreciate, whereas a company worth less than $50 million will be more volatile but have great potential for faster returns.

The perfect diversification is a mix of all sizes.

Exploring Internationally

Lastly, we can diversify across countries. Many people are afraid of investing internationally as they prefer to put their money where they’re comfortable. This is actually such a big issue that psychologists have researched and labeled it home country bias. Don’t fall for it! Purchasing companies in different countries will protect against the inevitable bear markets.

If you are worried about investing internationally, just stick to the developed markets. This includes the USA, Canada, Australia, Japan, the United Kingdom, and South Korea.

Hunt for the Good Candy

Before I started my annual night of trick-or-treating, I would gather with my like-minded friends and plan a route. This way, we would have a clear and defined strategy to follow. With only 3-4 hours available to fill our bags, we had to be efficient. Time could not be wasted on streets and communities that did not guarantee the good candy.

You should have the same mindset when managing stock portfolio. Have a plan and make it efficient. Only hold 20-30 companies, but diversify across industry, size, and country. Don’t waste time on stale companies that will only hinder your returns. Lastly, if it helps, gather with your like-minded friends to ensure you stay the course.

About The Author:

Colin Richardson is an intelligent investor, contrarian, and student of the world. His personal philosophy is to base reasoning not on speculation but rather on back tested systems and confirmation. Although he successfully completed the Canadian Securities Course certification, majority of his financial knowledge is self-taught. When not writing, he monitors a quantitative deep value stock portfolio.