Monthly Archives: December 2009

Too Much of a Good Thing?

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.

DiversificationSource: Investopedia

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.

What About Bonds?

Recently I came across a news item that caught my fancy:

“Corporate bond sales hit record. Corporate bond sales surged to a record annual high of $1.171T YTD – more than the $1.167T sold in all of 2007 – as companies take advantage of low interest rates to rebuild their balance sheets. Companies that could not sell debt during the financial crisis are borrowing more aggressively, and being careful to sell debt with longer maturities to avoid being trapped by refinancing risk as they were in 2008, analysts said. The bond sale surge was also supported by the FDIC’s debt-guarantee program – companies issued $200B of debt guaranteed by the FDIC this year before the program ended on Oct. 31.”

The rationale for companies issuing a record amount of bonds this year makes total sense to me – take advantage of the current low interest rates.  But if interest rates are going to rise in the future (it must be true – “everyone” says it going to happen…), why would investors want to buy this record level of bonds at these unusually low rates? Is a puzzlement…

I’ll be the first to admit that I am not an expert on bonds.  Most of my career has focused on the equity market.  To me, the formula for bond investing always seemed a bit simplistic – interest rates up, prices down, and visa versa.  Clearly this view grossly understates the complexity of the marketplace, but it is where I begin with bonds. Fortunately, I know a lot of very smart people who are very good at bonds.

So, I turned to some of my smart friends to answer the puzzling question above.  Through these discussions I learned a number of important things about the world in general and the bond market in specific.

  1. The World is a Safer Place Now. With both the credit crisis and recession fading into the past, investors are once again comfortable with owning assets other than cash.  Stocks still may be viewed with some skepticism, but bonds yielding 2-4% are much more attractive than cash yields near zero.  So part of the enthusiasm for bonds is an asset allocation shift from cash to bonds.
  2. Stimulus Money Needs a Home. The $3-4 trillion (more or less) in government stimulus money already spent needs to go somewhere.  We have seen the impact of all this liquidity in lots of places – commodities, oil, gold, stocks and bonds. Given the huge size of the bond market, it would not be surprising that it received a majority of this cash injection.  Oh, and the bulk of the approved stimulus spending is yet to come.
  3. Inflation vs. Deflation Debate Good for Bonds. Although many expect inflation to eventually pick up sometime in the future, some of the credible bond market commentators are still warning about the threat of deflation.  Deflation is especially pernicious because it’s so hard to fix (consider Japan’s 20-year fight with it) once it takes hold.  Whether or not deflation becomes a problem, the fact that it’s still being mentioned as a threat gives many bondholders comfort that inflation will not be a problem in the near to medium term and that interest rates may remain stable for longer than most expect.
  4. Low Interest Rates Benefit Many “Important” Groups. The aggressive monetary easing we are currently experiencing benefits a large portion of the economy, but especially the auto industry, the housing market, the banking industry (have you seen bank profits lately?), and other stressed groups.  Thus, bankers, politicians, unions, and lots of other highly-visible groups really, really like the status quo.  At some point, the Fed may see the need to raise rates, but we can image that Mr. Bernanke is being bombarded by many voices urging him to wait as long as he can.  This delay would be good for bond investors as well as these other groups.
  5. The Futures Market is Calm. Although not an exact guide for what may happen in the future, the Fed Funds Futures market can give us a clue what investors are expecting from short-term rates down the road.  Right now this market is looking at a 1.35% Fed Funds rate by the middle of 2011.  This too argues that few expect any kind of aggressive tightening of monetary policy within the next 18 months.

So, what’s not to like about bonds?  Well, low yield for one.  Is the 10-year US Treasury bond a steal at 3.4%?  We are still seeing some deals in the corporate arena, but for the most part bonds look like “everyone” already loves them.  Does this make me bearish on bonds?  Not really.  I can also see the logic of owning them versus cash.

I guess my view on bonds is mixed, but the current enthusiasm for bonds does, at the margin, make me a little more bullish on stocks.  Why so?  The investors who were able to leave the perceived safety of cash for a little more yield in bonds will eventually find bond returns unacceptably low and turn to stocks.  The fact that this hasn’t happened yet gives me comfort that the new bull market has room yet to run.