This week the Wall Street Journal ran an interesting story entitled, “What Are You Paying For?” The gist of the article was that many fund managers invest in so many stocks that their funds begin to look like the market. The author’s criticism centered on the fact that these managers are charging higher fees for services and performance that could be obtained via an index fund. He said, “’Closet index funds’ have higher fees than true index funds but don’t differ enough to justify the higher costs.”
I am not one to criticize any fund manager – I think their jobs are challenging enough without any kind of grief from me. If a fund manager can produce consistent above-market returns, I could care less how many stocks are in the portfolio.
But this article did get me thinking about the concept of diversification and made me wonder if one can have too much of it. Everyone knows the idea of diversification from the old saying “Don’t put all your eggs in one basket.” Investors should invest in a number of different stocks and asset types. But how many is enough and how many is too many?
We can attempt to answer this question intuitively. Everyone would agree that owning just one stock would be the riskiest investment possible. We can also agree that adding one more stock would reduce the risk a bit. As would the third, fourth, and so on. Reducing risk by adding another stock to the pot happens due to something called “correlation.” Because the price of a given stock is governed by its own fundamentals and investor perception of those fundamentals, it tends to move in a somewhat different pattern than other stocks. To the extent that two stocks tend to move differently from each other (that is, their correlation with each other is low), holding them both in a portfolio will reduce risk. Obviously, owning 10 energy stocks (whose correlation with each other will be high) will be more risky than owning 10 stocks from different sectors.
Aside: This may be a good time to talk a bit about risk. Risk is not the same as losing money in your investments. Risk, as most professional investors measure it, is the price volatility of the asset in question. One stock would have the most price volatility imaginable (up or down), and this volatility is reduced as we put more stocks into the portfolio.
The problem with an intuitive solution to this question is that it seems that a portfolio of 100 stocks would be 10 times less risky than a portfolio of 10 stocks. And a 1000-stock portfolio would be even better – that is, more diversified. The real solution is mathematical. The relationship between the number of stocks in a portfolio and its risk is not linear, it’s exponential. So at some point the addition of another stock to portfolio will reduce the risk only a very small amount. The chart below illustrates this.
So mathematically speaking, 20 seems to be a good number for optimal diversification. The problem here is that 20 names will rarely provide the industry sector diversification one may want. Although the “right” number remains a point of discussion, many fund managers who like to keep the stock count low will agree that something around 30 is a good number.
This has been the guiding principle for diversification my entire career. While I was thinking about this issue, I did a quick check on my personal portfolio. Sure enough – it has 28 names in it. Just about where diversification feels “right” to me.
Much of the commentary out there seems to suggest that many individual investors have too few stocks in their portfolios. Often these “portfolios” are just a numbers of stocks the individual selected or was recommended by interested parties. A “real” portfolio, in my opinion, is one which contains enough stocks in different sectors to allow the magic of diversification work. Investors should also avoid the temptation to own 100 (or some other large number) stocks simply for diversification reasons. Like many things in life, moderation seems to be the answer to how many stocks truly make one’s portfolio diversified.