Diversification: The right number of baskets

If investors are not supposed to put all their eggs in one basket, then how many baskets are best?

Diversification is one of the key concepts of investing. It’s designed to protect from gyrations in the market by spreading risk among a variety of companies and assets. When some investments move up while others move down, they can serve to offset each other, and reduce bumps in the road. Diversification affects every investment portfolio and has far reaching implications on your expected rate of return and expected risk over time.

 The first studies of diversification appeared in the late 1970s and tackled the subject from an academic point of view. Ed Elton and Martin Gruber from NYU Stern School of Business measured how much risk is reduced by adding one stock at a time for an average hypothetical portfolio of US stocks. Their research, illustrated in the chart below, shows the biggest risk reduction happens when investors go from holding one stock to a basket of 10 stocks. This can reduce risk by 25% on average. From 10 to 30 stocks there is some risk reduction but not an overly perceptible amount, only 3%. Most interesting is that there is little difference in risk between holding 30 stocks and 400, only a reduction of 1.6%. This has big implications for all investors, but especially high net worth portfolios.

Many high net worth investors own portfolios with well over 30 individual stocks. Although well diversified, such large multi-stock portfolios may hold a different kind of risk due to their diversity. What those investors may not realize is they might be better off with an exchange traded fund (ETF) that holds +30 similar stocks, but costs much less to operate. The savings earned from reducing trading and management expenses for multi-stock portfolios can add significant performance, without increasing risk over the long term. This should be closely examined for investors holding US or foreign dividend investments, preferred shares, corporate bonds, high yield bonds, and especially Canadian dividend stocks.

Professionals with a good understanding of diversification often use the term “diworsification” to explain what happens when investors don’t diversify properly, or misapply principles without knowing it. The term was first coined by legendary investor Peter Lynch in his book One up on Wall Street. Although it doesn’t take a math PhD to figure out if you’re diworsified, the math can be beyond the scope of most investors. Diworsification happens when investors add too many correlated investments without a plan for dealing with the correlation risks. This can be the case if an investor holds a lot of stocks from one industry and they all go down together, like bank stocks in 2008 or gold stocks in 2012. On the other hand, diworsification also happens when investors water down their returns by being overly-diversified. From Elton and Gruber’s research, we see that portfolios of over 20 stocks can have a hard time outperforming the market because they can act so similarly to it.  As much as diversification limits risk, it can also limit reward.

In the Growth Portfolio, we hold a smaller number of stocks so we don’t diversify-away our potential for gains. We have clearly identified our edge and our interest is in maximizing that exposure. Although we still rely partly on diversification to protect capital, we add other risk management tools to ensure we’re even more protected for our level of exposure. The Income Portfolio, which holds ETFs, relies more completely on diversification, but also uses additional risk management tools as backup.

With all these eggs, then, the ideal number of baskets relies on your expectations for risk and return. Investors who want average risk and average return would be well served with an ETF or muli-stock portfolio. Investors interested in better performance might hold less than 10 stocks, chosen carefully, in combination with proven risk management tools. No matter which direction you choose, keep an eye on your baskets.

Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.