Investment diversification and maximizing returns
If you do a web search for “rules of investing” you will get numerous lists. Rules like “don’t try to time the market” , “think long term”, “minimize fees” and other related concepts.
However, there is one item that will show up on almost every single list: diversify your portfolio. The idea is that by holding various types of investments you spread out volatility. In addition to holding quantity, adding assets that have reduced or even inverse correlations to each other can lower overall volatility. For example, while the stock market is going down, bond returns may go up and by holding both you can soften wild swings. However, for our long-term investments why sacrifice our long-term returns to minimize short-term volatility? Historically we know that the stock market has greatly outperformed fixed income assets. So logically, to maximize return, investing 100% in stocks for your long-term goals is the way to go. And in recent history we have seen cryptocurrency assets greatly outperform the stock market. Causing some to recommend that at least some of your long-term investment allocations go towards cryptocurrencies.
Using research from Thomas Howard, John Evans and S.H. Archer to help quantify what diversification means in a real world application: More is not always better.
TLDR at the end
When is diversification most useful?
If you are only holding a couple of stocks, you can benefit from the advantages of further diversification. In this case, more is likely better.
When grouping assets with similar expected future returns.
The reasoning behind this is that because the expected returns are similar, but since volatility is reduced, you actually increase the annual compound return of the combined investment.
With assets that have vastly different expected returns (like a bond compared to stock, or even 2 stocks with different future potential), diversification tends to eat away at your long term returns.
How many stocks are enough?
So how many holdings are enough to be adequately diversified? 5 stocks? 500 stocks? The truth is there is no cosmic universal number, but research by Stephen Archer and Vince Evans illustrates the benefits of diversification as they relate to specific numbers of holdings.
You can see from the chart below, that 20 holdings gets you about 91% of the diversification benefits. After 20, the incremental benefits of additional holdings become much smaller. 50 holdings gets you about 96% of the benefit.
(Chart derived from Evans & Archer research)
Logically, based on the chart, we can assume that somewhere between 20 and 50 holdings gets us enough diversification. Some fund managers like Thomas Howard say that you are better off with fewer picks that you are confident in.
Don’t get hung up on the perfect number of holdings, it does not exist. The takeaway, pick your top 20 or so highest conviction plays for the long-term. Don’t add more holdings just to fill space, our goal is to maximize long-term return. If you have 50 high conviction investments, as long as you can reasonably keep up with the necessary research, go for it. You may also have some long-term speculative investments that you would like to allocate a few percent of your portfolio too.
ETFs and mutual funds have made it very easy to buy into a fund and immediately gain exposure to dozens of individual stocks with just a few clicks. For those worried about keeping up with a couple dozen stocks, you could instead allocate to just a few specific ETFs. There is a good chance the ETFs are over diversified, but if this is more comfortable and easier for you to manage, great. Stay in the game.
Why do funds hold so many?
If diversification is not all it’s hyped up to be, why do so many ETFs and mutual funds carry a hundred or more stocks?
Imagine accumulating so much money from investors that you run out of places to put it. Fund size makes it difficult to concentrate on only a few stocks. In cases like this, funds look for additional investment opportunities to fill this need.
Funds add more stocks to avoid style drift. Often not by their own choosing, funds are assigned an index, like large cap growth or small cap value. When you deviate from this (also known as style drift) your fund is perceived as more risky even if your drift was intentional and has led to higher returns. Go figure, sometimes the tools used to compare investments, often confine them to lower returns.
Lastly, there is still heavy public perception that more holdings are better and safer. From that perspective it’s an easy sell for funds to convince novice investors that they are worth investing in, simply by showing how many holdings they have.
Take a look at some hedge funds
In contrast to some of the large index ETFs, many hedge funds have holdings more in line with the 20 - 30 stocks mentioned previously.
Akre Capital Management
Akre Capital usually holds about 30 stocks with their top 10 combining for more than 70% of their portfolio. See the link above for their top 10.
Berkshire Hathaway
Warren Buffet and Berkshire Hathaway typically carry less than 50 stocks, but their top 10 picks often make up more than 80% of their total investment. See the link above for their top 10.
Tiger Global Management
The tech focused Tiger Global does carry more than 100 holdings, but their top 10 picks make up more than 40% of their portfolio and the top 20 make up more than 60%. See the link above for their top 10.
Pershing Square Capital Management
In contrast, Bill Ackman and Pershing Square typically carry less than 10 holdings. See the link above for their top holdings.
ETF portfolios
If keeping track of a few dozens stocks does not sound appealing to you, you’re not alone. Try these more manageable ETF portfolios to save yourself a headache.
Dividend growth portfolio for those looking for battle tested companies that have consistently raised their dividends year after year.
Growth or Value portfolios for those looking to gain stock market exposure in growth or value styles.
Aggressive or Moderate ETF portfolios for those who are not ready to fully commit to an all-stock investment for their long term goals. Both of these contain bonds, so expect lower long-term returns.
What about uncorrelated assets?
Oftentimes as part of diversification, low correlation or uncorrelated assets may be recommended. Stocks and bonds for example. When the stock market is going up you can expect bonds to underperform, but as soon as the stock market starts to reverse, bond returns start to increase. This is more prevalent during times of high economic uncertainty or volatility in the stock market. No doubt, people got burned in the Dot-com bubble and the Great Recession of 2007 - 2008. And many of these investors were scared to get burned again. The question becomes why would you purposefully reduce your expected returns? Again, remember this applies to our long-term investments. Sure, short-term holdings you’ll want to be more conservative and uncorrelated assets may make more sense. Don’t sacrifice long-term returns to mitigate short-term market volatility.
Final Thoughts
If you are a more risk averse investor, you can still apply these principles, just in a scaled fashion. If adding a few more low volatility stocks or ETFs makes you more comfortable, go for it. Better to keep yourself invested, even if it’s in a reduced capacity.
Diversification has benefits, but you can go too far. You may have seen the term diworsification, basically adding holdings that diminish your returns. Your best bet is to work with a trusted financial advisor, tested stock picker or a proven hedge fund manager and buy a smaller group of your highest conviction picks. Confidence is key to maximizing long-term returns.
TLDR::
Investment diversification is beneficial up to a point.
Too much diversification can eat away at your long term returns.
Somewhere between 20 and 50 holdings likely gets you enough diversification.
Go with a smaller list of high conviction picks to maximize long-term returns.
If you are curious what average returns might look like for various asset allocations (stock/ fixed income), see Vanguard's comparison charts.
If you are curious to see how investments can grow over time you can try this online investment calculator.
