The Downside of Diversification

From last weekend’s Intelligent Investor column in the WSJ by Jason Zweig.

More Stocks May Not Make A Portfolio Safer

Not putting all your eggs in one basket is the most basic principle of investing. It also may be the hardest to get right.

Investors have long been told by stockbrokers and financial planners that to have a properly diversified stock portfolio, you need shares in only 10 to 40 companies. Even the great investment analyst Benjamin Graham urged “adequate though not excessive diversification,” which he defined as between 10 and about 30 securities.

As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time.

But this research on diversification was based on the average results of a large number of portfolios randomly generated by computer.

Something entirely different happens when flesh-and-blood humans try to pile up stocks one at a time.

Don Chance, a finance professor in the business school at Louisiana State University, asked 202 business students to select one stock they wanted to own, then to add a second, a third and so on until they each held a portfolio of 30 stocks.

Prof. Chance wanted to prove to his students that diversification works. On average, for the group as a whole, diversifying from one stock to 20 cut the riskiness of portfolios by roughly 40%, just as the research predicted. “It was like a magic trick,” says Prof. Chance. “The classes produced the exact same graph that’s in their textbook.”

But then Prof. Chance went back and analyzed the results student by student, and found that diversification failed remarkably often. As they broadened their holdings from a single stock to a basket of 30, many of the students raised their risk instead of lowering it. One in nine times, they ended up with 30-stock portfolios that were riskier than the single company they had started with. For 23%, the final 30-stock basket fluctuated more than it had with only five stocks in it.

The lesson: For any given investor, the averages mightn’t apply. “We send this message out that you don’t need that many stocks to diversify,” says Prof. Chance, “but that’s just not true.”

What accounts for these odd results? Leave it to a professor called Chance to show that even a random process produces seemingly unlikely outliers. Thirteen percent of the time, a 20-stock portfolio generated by computer will be riskier than a one-stock portfolio.

Humans are even more fallible. Prof. Chance’s students started by picking companies they were familiar with: Exxon Mobil, Wal-Mart Stores, Apple, Starbucks, Nike and the like. But after a handful or two, they ran out of household names. By the fifth company, they were picking stocks that had less than half the market capitalization of the one they started with. Adding these riskier small stocks made their portfolios more volatile. And one in five students picked as a top holding, perhaps because Prof. Chance happened to schedule the assignment near Valentine’s Day, when they may have had bouquets on their minds. (They weren’t just picking from the top of an alphabetical list; almost nobody chose 1-800 Contacts.)

These results are no surprise to Allan Roth, a financial planner at Wealth Logic in Colorado Springs, Colo. “Humans can’t think randomly,” says Mr. Roth. “Once people think of Exxon Mobil, they’re a lot more likely to think of Chevron or another oil stock. For a lot of investors, diversification is like doing a word-association game.”

Gur Huberman, a finance professor at Columbia University, points out that investors tilt toward stocks that match their own beliefs about risk. People who regard themselves as risk-averse will assemble portfolios of highly similar stocks that all seem to be “safe.” The result, paradoxically, is a risky portfolio with every egg in one basket. As bank-stock investors learned last year, owning a greater number of the same kind of company isn’t diversification at all.

According to the Federal Reserve’s Survey of Consumer Finances, 84% of households that own shares directly have no more than nine stocks; 36% hold shares in only a single company.

That’s way too few. But 30 or 40 isn’t enough either. If you want to pick stocks directly, put 90% to 95% of your money in a total stock-market index fund, which will give you a stake in thousands of companies at low cost. Put the rest in three to five stocks, at most, that you can follow closely and hold patiently. Beyond a handful, more companies may well leave you less diversified.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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2 Responses to The Downside of Diversification

  1. Kirk Kinder says:

    Sounds like core and explore to me. Get your total diversification with the core of your assets and attempt alpha with the remainder.

  2. Alex Lopez says:

    This is a great post. I will share this in my Linkedin.