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Diversification Myths: Why Are You Investing In Individual Stocks?

By Chris Gilbert The age old question of exactly how many stocks to hold is likely never going to be definitively answered. There are entire books, even courses, on the subject after all. Since portfolio construction is more of an art than a science, in this post I want to break down relevant studies, examine historical data, and analyze some of the best investors in an attempt to come up with the optimal strategy . As always, please share your comments and thoughts below! Talking Points Diversification by the numbers Myths of diversification Why are you investing in individual stocks? “Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett By The Numbers My investing strategy, which is definitely not perfect, consists of holding relatively few stocks (around 10 or so). This is because I want to invest in wonderful companies purchased at attractive prices. I have found that these opportunities, especially of late, don’t seem to come around all that frequently. This also makes me a big believer in holding a decent amount of cash in my portfolio as well. But why adopt this strategy? It’s simple logic, the more stocks you own, or the more diversified you are, the less likely you are to underperform the market. By this same logic, however, you’re also much less likely to outperform the market. Say you own 2 stocks and one doubles while the other stays flat. You still earn a 50% return. With 4 stocks and one doubling – a 25% return. What about more? Say you own 10 stocks and one doubles while the others go nowhere. You’d still earn 10%. 20 stocks… 5%. 100 stocks… 1%. While this may be an oversimplified example, you get the point. The more stocks you own the more your results trend toward average. But let’s look at some more numbers. In the book, Investment Analysis and Portfolio Management , Frank Reilly reviewed studies regarding randomly selected stocks and found that as little as 12 stocks could attain around 90% of the maximum benefits of diversification. He also goes on to note if the individual investor is properly diversified, 18 or more stocks = full diversification according to his research, then the investor will average market performance. According to Mr. Reilly the only way to beat the market is by being less than fully diversified. In his book, You Can be a Stock Market Genius , Joel Greenblatt came to a similar conclusion. Greenblatt found statistics that showed owning only 2 stocks could eliminate 46% of non-market risk. This number climbs to 72% with 4 stocks, 81% with 5 stocks, and 93% with a 16-stock portfolio. As you can see, the amount of non-market risk can be decreased with the more stocks you own. Which was already obvious. But let’s keep going. You would need to own 32 stocks to eliminate 96% of non-market risk and a whopping 500 stocks to almost eradicate it (99%). Greenblatt’s point is, there seems to be a pattern of diminishing returns after a certain number of stocks. Personally, I would argue maximum benefit is to be had between 8-16 stocks. Myths Of Diversification Myth #1 – You can diversify away risk One of the main reasons investors are afraid to concentrate their portfolio is the belief that it’s too risky. While it may be true to a point, can you ever totally remove risk? We’ve already seen you can partially remove non-market risk, also known as unsystematic risk, by holding more stocks. But systematic risk is a different animal. This type of risk cannot be diversified away. Consider all of the factors that affect the stock market such as macroeconomics, irrationality, or interest rates. You’ll never be able to remove these elements from the equation if you own 1,000 stocks. Think of systematic risk as the inherent risk of investing in stocks. Myth $2 – Overdiversification is safer So what, you say. It still seems safer to own 100 stocks compared to 10. But is it? While you may dilute your unsystematic risk, how much do you really know about your portfolio? Would you even know which stocks you own? Maybe you invest in index funds, which is totally fine for some by the way (more on that later), but if you’re an individual investor and you own 40+ stocks, there is now way to know the ins and outs of every one. We’ll call this practical risk. Practical risk means you may lose your main advantage in the stock market, competitive insight. When you overdiversify, you may miss out on a great opportunity and be saddled with a regrettable investment because your focus is stretched too thin. Myth #3 – Diversification can increase success I’ve already explained two reasons why this is a myth. The more stocks you hold, or the more diversified you are, the more your results trend toward average. This inherently decreases success, unless you want average. Secondly, when you own too many stocks, practical risk increases. Overdiversification makes it very difficult to invest in wide-moat, wonderful companies. There simply isn’t that many great opportunities available at any given time. This also decreases chances of success. Lastly, when you begin to invest in many different stocks just to increase diversification, you increase portfolio turnover. This inevitably leads to more fees and commissions, which also puts a damper on potential success. “We believe that almost all really good investment records will involve relatively little diversification. The basic idea that it was hard to find good investments and that you wanted to be in good investments, and therefore, you’d just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, it’s proven to be an obviously good idea. Yet 98% of the investing world doesn’t follow it. That’s been good for us.” – Charlie Munger Why Are You Investing In Individual Stocks? So we’ve seen the more stocks you hold, the less chance you have of underperforming the market. This also means the less chance you have of outperforming the market as well. By this logic, the only way to increase our chances of success is to hold less stocks than a completely diversified portfolio. By doing this, we take on the inherent risk of owning stocks, so the real question to ask yourself is why are you investing in individual stocks? “If you want to have a better performance than the crowd, you must do things differently from the crowd.” – John Templeton If your answer is to invest your money in a proven vehicle that, historically speaking, beats all other investment options… and you don’t want to take the time and effort to perform proper fundamental analysis on each and everyone of your stocks, then I would recommend an index fund . I mean let’s face it, we’re not all Warren Buffett or Peter Lynch and we’re likely not going to be. But there is still no situation I would ever recommend going out and buying 50 some odd stocks just to say you’re diversified. As we just talked about, this can actually increase risk and reduce your chances of success in a variety of ways. Index funds, on the other hand, are a great way to expose yourself to the stock market and are likely to beat every fund manager over the long haul anyway. Now, if you’re answer is you think you can beat the market, then I recommend you keeping a fairly concentrated portfolio of 8-12 stocks. Why 8-12? Well, for one, you don’t want to be too diversified for all the reasons stated above. And secondly, we’ve seen you can only diversify so much before the benefits begin to severely drop off. Lastly, if you’re really practicing a true value investing strategy, it’s unlikely you’re going to find an abundance of opportunities out there. To mitigate risk, search out high-quality companies with a competitive advantage, and purchase when they’re selling at a discount to their intrinsic value. By concentrating your portfolio, you can obtain a thorough understanding of each company, and coupled with a value investing strategy, decrease risk while increasing returns. Summary Strictly reviewing the numbers, it makes little sense to overdiversify your portfolio. Overdiversifying will not eliminate all risk nor increase your chances of success. If you are willing to practice a value investing strategy and research each of your investments, then focus your portfolio to 8-12 stocks. If not, invest in an index fund. Disclosure: None

America’s Retirement Crisis: Financial Advisors’ Daily Digest

SA Dividends, Income & Retirement Editor Robyn Conti here, subbing in for Gil, who’s observing Passover this week. I’ll do my best to fill his very talented and knowledgeable shoes and continue to keep you up to date daily on the latest FA analysis and news here on Seeking Alpha. It’s no secret that America’s retirement system is in crisis. We are well aware that Social Security and Medicare need shoring up, and that workers today aren’t saving enough to create the financially secure and comfortable retirements most of us dream about. SA contributor Kevin Wilson presents a rather gloomy picture of how truly dire the circumstances of our nation’s retirees and near-retirees are in Of Mice And Men: The Retirement Crisis In America . He aptly points out that traditional retirement planning assumptions have broken down over the past few years, and that savers can no longer rely on tried-and-true investment methods like asset allocation because expected returns across all asset classes are bunk due to central banks’ insistence on ZIRP and NIRP policies across the globe. So what does that mean for the best laid plans of retirees and near-retirees? Wilson writes: The crux of the problem then is the low expected returns on all types of investments, as discussed briefly above and mentioned by many other analysts. As a consequence, the average person must either withdraw much less from their investments in retirement than they actually will need (i.e., accept a lower standard of living), or as mentioned above, retire significantly later than planned or save a multiple of what was assumed above. National data suggest that the average investor has been chasing yield in a vain attempt to make up the difference through investment magic. Unfortunately, yield chasing doesn’t end well historically, and there are already signs that it is failing now… Wilson then goes on to cite programs that desperately need reform at the government level, i.e., Social Security and Medicare — which he calls the “bedrock” of retirement planning — and discusses strategies for addressing the problem of low investment returns. It’s an interesting read, and Wilson makes several valid points that, in this author’s humble opinion, hold a lot of water, and are definitely worthy of consideration by our lawmakers and others with the power to affect the changes we all want to see in the retirement world. In defiance of reliance on Social Security and Medicare, self-proclaimed “geezer” George Schneider summons the wisdom of the Oracle of Omaha Warren Buffett in his piece, How Greedy Retirees Steal Candy From Fearful Babies , touting the old adage investors know so well: “be greedy when others are fearful.” Schneider touts interest rate-sensitive stocks, especially REITs, advising that now is the time for the income-oriented and dividend-hungry to jump in while prices are down and investors are fearful, to reap those profits when markets “normalize.” Here are a few more posts from the day that contain items of interest for financial advisors: What are your thoughts? Are recession fears overblown? Comment below.

These Funds And ETFs Are Now Poised To Outperform

For several years now, I have been recommending that investors put a somewhat higher emphasis on two categories of stock funds/ETFs, namely Large Value and International, along with a lower emphasis on domestic Large Growth and Small-/Mid-Cap. The reason is straightforward to me although less than obvious for most: While the former two categories have consistently trailed US broad stock benchmarks over the last several years, the latter two have at times exceeded them. In the sometimes upside down world of fund investing, there is a tendency, usually after a considerable number of years, for underperforming and relatively weak performing categories to switch places with the well-performing ones. The same is true for ETFs. Finally, after some trepidation that the approach was not working as expected, except in the case of Small-Cap funds which have indeed gone from being stellar performers to among the weakest over at least the last year, it now appears that the strategy may be beginning to pay off. However, it has been a frustratingly long wait, although an interval of one or two years for such an expected turnaround should not be regarded as particularly unusual. Large Value I believe the long expected rotation to value stocks may now be underway. So far this year, all three value stock category averages, Large, Mid-Cap, and Small, are running well ahead of their three growth stock brethren categories. The average Large Cap Value fund is outperforming the average Large Cap Growth fund by over 4%. While such a short spurt may not in itself seem significant, on a quarterly basis one has to go back consecutive 29 quarters, to the third quarter of 2008, to see an outperformance by Large Value over Large Growth that is that large. Note: Performance figures cited are through Apr. 20 unless otherwise noted. If Large Cap Value funds continue to outperform Large Cap Growth at the same pace for the rest of the year, there would be a huge 12% spread by year’s end. While such a large disparity might seem highly unlikely, it cannot be totally dismissed. If you compare the performance of two Vanguard index funds, Vanguard Index Value (MUTF: VIVAX ) and Vanguard Index Growth (MUTF: VIGRX ) as proxies for each of these categories, you will see that over the last 9 years, going back to May 1, 2007, Value has gone from a NAV (Net Asset Value) of 27.85 to only 33.03 for a cumulative gain of 18.6% (not annualized, excluding dividends). Growth, on the other hand, has gone from a NAV of 31.44 to 55.64 for a gain of 77.0%. The difference is a whopping 58.4%. When averaged out over the 9 years, VIGRX has exceeded VIVAX by about 6.5% per year. You would find the same discrepancies if you looked at the ETF equivalents of these funds, Vanguard Value ETF (NYSEARCA: VTV ) and Vanguard Growth ETF (NYSEARCA: VUG ), since they encompass the identical portfolios as these mutual funds. Since Large Value has been so far behind, merely gaining back one year of this outperformance for the rest of this year would bring it close to an 11% outperformance of Large Growth. However, it seems far more likely that the category will see smaller outperformances over quite a few of a number of upcoming years to enable it to eventually catch up to Large Growth. I, for one, believe such an equalization is reasonable to expect. In fact, history shows that value stocks tend to be better long-term performers than growth stocks, supporting the potential for a big upcoming turnaround. What else might argue for my suggested Large Value overweighting? Evidence suggests that as the Fed raises interest rates which they already have begun to do, value stocks tend to get stronger. (For a further discussion of this, see the following article .) Further, with growth stocks having reached a greater degree of overvaluation in the recent past than value stocks (although each category is more fairly valued now), Large Growth stocks would seem more likely to suffer if and when investors become unnerved and decide that they need to protect their profits. International Stocks Even more severe than the long-term underperformance of value stocks has been that of International funds/ETFs. When one compares the performance of the average International category fund with that of the S&P 500 index over the last 10 years (thru Mar. 31), one finds an annualized total return for the foreign category of 1.8% vs 7.0% for the US-only index. Emerging Market funds have done only slightly better at 2.5%. Is there any sign of a possible turnaround here? While only tentative given the short time period, a proxy for the entire International category, the Vanguard Total International Stock Index Fund (MUTF: VGTSX ), has gone from a NAV of 12.87 on 01/20/2016 to 14.98 on 4/20 for a 16.4% gain over 3 mos. Looking back over its quarterly returns, one has to go back to the 3rd quarter of 2010 (21 consecutive quarters ending this past Dec.) to find a gain that big. The same can be said for emerging markets. Looking at the Vanguard Emerging Mkts. Index Fund (MUTF: VEIEX ), the NAV has gone from 18.06 on 01/21/2016 to 22.38 on 4/20 for a gain of 23.9%. To find a closely comparable quarterly gain, one would need to go back to the 3rd quarter of 2009 (25 consecutive quarters, ending this past Dec.). Once again, you would get essentially the same results as above with Vanguard Total International Stock ETF (NASDAQ: VXUS ) and Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ). For both Large Value and International stocks, while not proof that a longer-term turnaround will be forthcoming, the data seem to be possibly suggesting that these categories of funds/ETFs will be better places to emphasize within a diversified portfolio over the next few years. With International stocks, and especially emerging markets relatively undervalued, these categories of funds/ETFs would appear more appealing than US-only stock funds when looking at annualized return potentials over at least the next several years. Still, there can be many “false dawns” where a category seems to be making a comeback but, not much later, falls back again. And, even if the outperformances I expect occur, it may not mean excellent absolute returns but only relatively better returns than the aforementioned competing categories. But especially when viewed over the longer term, an approach that incorporates the notion of comebacks by underperforming categories often seems to be an effective strategy when deciding which funds to emphasize within portfolio whenever considering periodic changes. But turnarounds don’t just happen because one “thinks” they should happen. The necessary ingredient is typically that the category in question has either become under-/overvalued, or, a major and usually unexpected development occurs within the markets that creates a nearly totally new mindset in investors, or both. While the second of these conditions is almost impossible to predict and is relatively rare, the first can be recognized by investors who are willing to pay close attention to relatively extreme over- or under-performance within the category averages. Disclosure: I am/we are long IN ALL OF THE MUTUAL FUNDS MENTIONED. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.