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How Much Diversification Is Too Much?

Determining the Right Way to Diversify a Portfolio

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Most investors are familiar with the concept of diversification. By limiting exposure to risks associated with individual stocks, investors can enhance their long-term risk-adjusted returns. Fewer investors realize that there are limits to effective diversification; too much diversification can actually harm returns by increasing transaction costs and portfolio complexity without reducing risk. In this article, we’ll take a look at how to achieve optimal diversification.

How Many Stocks in a Portfolio?

Harry Markowitz outlined Modern Portfolio Theory in a 1952 research paper and later expanded upon the concepts in a 1959 book. The theory maximizes a portfolio’s expected returns given a set of risks by choosing the ideal mix of assets. Since its introduction, the theory has become a staple in the financial world, making it easier for asset managers to create and maintain an ideal mix of fixed income and equities in order to enhance long-term risk-adjusted returns.

Modern Portfolio Theory suggests holding approximately 20 different equities in order to achieve diversification. While a single equity may have a standard deviation of nearly 50%, the risk declines to about 20% when 20 equities are added to a portfolio. Increasing the number of equities from 20 to 1,000 only reduces this risk by about 0.8% which is hardly worth the effort when taking into account transaction costs and the time required to manage those positions.

In summary, Modern Portfolio Theory indicates that the risks associated with holding specific stocks are sufficiently minimized with a portfolio of 20 where the remaining risk is market related.

What Kinds of Stocks Are Ideal?

Simply holding 20 different equities isn’t sufficient to diversify a portfolio; rather, investors must ensure that these equities are sufficiently uncorrelated. For example, a portfolio consisting of 20 different retail brands would perform poorly if consumer spending were to decline. A diversified portfolio that mixed in consumer non-discretionary equities and other sectors would perform much better since some sectors aren’t as sensitive to consumer spending.

Investors can also decrease correlation between equities by investing in different countries around the world. For instance, a slowdown in the U.S. may not affect faster growing emerging markets or developed countries that are better positioned. Most financial advisors recommend holding at least 15% to 20% of their portfolio in foreign securities, although the increasing correlation within U.S. markets could push the ideal figure higher in the future.

Why Not Hold More than 20 Stocks?

Over-diversification involves greater transaction costs and portfolio complexity. For instance, an investor purchasing 100 equities may spend $5 per transaction at a cost of $500.00 while an investor purchasing just 20 equities may spend just $100.00. Managing 100 positions may also be five times more time consuming than managing 20 positions - and time is money. As a result, most investors are best off holding closer to 20 equities rather than many more.

Aside from the greater transaction costs and complexity, over-diversified portfolios often have less upside potential. For example, an all-world fund holding thousands of equities will perform exactly the same as a benchmark since they are often used as benchmarks. Investors holding just 20 equities may have greater upside potential by selecting the best companies in certain industries or countries around the world instead of simply buying them all.

What About Holding ETFs and Mutual Funds?

Exchange-traded funds (“ETFs”) and mutual funds often hold hundreds or thousands of equities which means they may be over-diversified. While investors don’t have to pay the transaction costs associated with buying 1,000 individual equities, these costs are often built into the fund’s expense ratio that’s expressed as a percentage of assets. High expense ratios can eat into overall returns and can vary depending on the fund’s turnover ratios.

It’s also worth nothing that ETFs and mutual funds may not be properly diversified even though they hold hundreds of equities. For example, industry-specific ETFs or actively managed ETFs may hold a large concentration of equities that are highly correlated with each other. As a result, investors should consider how these correlations impact the rest of their overall portfolio in order to ensure they are properly diversified.

Key Points to Remember

  • Modern Portfolio Theory recommends holding approximately 20 different equities in order to minimize individual risks and enhance risk-adjusted returns.
  • The equities held in a portfolio should be diversified both by sector and by country in order to ensure they are sufficiently uncorrelated.
  • Many ETFs and mutual funds may not be properly diversified, and investors should look at their holdings and expense ratios to determine if they’re the right fit.

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