Have you ever wondered how many stocks is the right number for a stock portfolio? Many investors ask this question and have come up with several different approaches. Some investors choose highly concentrated portfolios with less than 10 stocks, while others choose extremely diversified portfolios with over 1000 stocks. Most are somewhere in between. Let’s take a look at the role diversification plays in a portfolio.
Why use diversification?
Most investors diversify to reduce the loss in their portfolio when some of their companies perform poorly. Imagine a portfolio with shares in only one company. What happens to this one company determines the entire return for the portfolio. If the company goes bankrupt, the entire portfolio will be wiped out. Even if the single investment in the company has a positive expected value, the future is uncertain and the chance of losing money will eventually cause a loss.
To illustrate, we can use an example with a rigged coin. The coin has a 99% chance of landing on heads where money doubles, but a 1% chance of landing on tails where all the money is lost. A gambler betting their entire bankroll on the coin toss might double their money several times, but given enough plays, will eventually hit the 1% chance of loss and lose all their money. It doesn’t matter if they double their money once, twice, or even 100 times due to the high expected value because the eventual outcome is 0.
Unsystematic risk or company specific risk
Each company has their own unique characteristics and unique challenges. A high end boutique retailer has a completely different business model from an oil and gas company even though both can be profitable. Competitive dynamics and business threats are also different for both types of companies so if an investor buys both, they reduce the danger from each specific risk on their entire portfolio. That is, if one company fails because of an industry or company specific risk, the other can make up for it.
This is usually the case for a diversified portfolio. Buy a bunch of companies with positive expected value for a portfolio and diversify away the unsystematic risks. Going back to our coin example, this would be like flipping 100 coins at the same time, although each of the coins would be slightly different from each other. However, there is another issue. What happens if all the coins land on tails at the same time? While remote, it is still a possibility.
Systematic risk or market risk
Although companies are different from one another, they are all reside in the same world and are connected. When something impacts the entire system, the entire market moves. Take for example the great financial crisis of 2008. Although the fallout began with toxic mortgage backed securities, it quickly spread to other parts of the economy. Almost every stock during that period of time declined and diversification among many different types of companies did little to save a stock portfolio. All the coins landed on tails.
Fixing the gambler’s ruin with the coin toss
As we have seen, a high positive expected value with many simultaneous coin tosses is not enough for our gambler coin tosser to win in the long run because eventually they will hit the outcome leading to a complete loss.
The solution to the problem is to manage the bankroll and size the positions appropriately. The size of each bet the gambler makes should scale up or down as the portfolio changes and the gambler should never have a situation where the entire bankroll is used on bets. A system such as the Kelly Criterion might be helpful to look at, but keep in mind that there are differences between stocks and coin tosses that make it difficult to calculate the inputs for such formulas.
A look at diversified and concentrated investors
Investors with highly diversified portfolios generally invest based on quantitative factors. The portfolio might have a bunch of different stocks trading at a cheap valuation based on factors such as a low P/E ratio or a low P/B ratio. Although many of the companies might fail completely, the entire portfolio as a whole has a positive expected value. For example, Walter Schloss created a large portfolio of cheap stocks based on valuation and compounded by over 20% a year from 1956 to 1984.
As a counter example, Warren Buffett likes to have a concentrated portfolio in order to put the most money in his best ideas. His investment in American Express during his partnership days was over 40% of his entire partnership’s portfolio at one point. At the time, American Express was faced with a company crisis due to a salad oil scandal in 1963. Warren Buffett successfully realized that the setup back temporary and realized that it is a good time to buy.
To diversify or not to diversify?
Although both diversification and concentration can work and achieve good results, the choice ultimately depends on the individual. Someone who is able to withstand the movements in a volatile portfolio can handle the emotional roller coaster ride of having a concentrated portfolio better than someone who is unable to do so. Also, the investment style plays a role. Investors who favor high quality companies are usually forced to have a more concentrated portfolio because there are fewer companies that meet their quality standards. The rare exceptions are when the entire market crashes and many good companies are available at cheap prices.
Although diversification has been called a free lunch, it doesn’t completely eliminate all risks from a portfolio. It can only reduce unsystematic risks that are specific to individual companies or industries. Systematic risks that affect the entire market still exist and it is perhaps equally important to consider position sizing to prevent a scenario that causes a complete loss.
For most people, a diversified portfolio with dollar cost averaging is a good option. Finding the best investments out of all the different stocks that are available is a challenging task that requires a lot of time and effort.