“Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.” Ecclesiastes 11:2
˗ King Solomon
Don’t put all your eggs in one basket!
Over the Easter holiday I was reminded of this often-used idiom on investing – more specifically on diversification.
At the Easter egg hunt at church, one particularly determined young lady (4-years-old) had her basket overflowing to the point that the wicker handle released from the basket on one side just as she reached the top of the steps. Several dozen plastic eggs spilled down the steps much to the excitement of the other kids coming up.[1]
Even a 4-year-old can comprehend the benefits of distributing her wealth once it has been collected.
The concept of diversification is as old as transporting spices along the silk road or storing Egyptian crops along the Nile. More recently, it is a central theme of Modern Portfolio Theory (MPT)[2] developed by Harry Markowitz in the 1950s. The basic tenant establishes a need for owning multiple investments to lower the volatility of an investment portfolio. A one-stock portfolio is likely to be more volatile than a 100-stock portfolio, but what is the right number? Thankfully, many academic scholars and investment theorists have completed volumes of research on the topic.
Earlier research places the number between 10 and 30 stock positions to achieve proper diversification.
Ben Graham, The Intelligent Investor, 1949 – 10-30 stocks
Evans and Archer, The Journal of Finance, 1968 – 10 stocks
Burton Malkiel, A random Walk Down Wall Street, 1973 – 20 stocks
More recently the number has steadily increased primarily based on an increase in investable markets.
Campbell, Lettau, Malkiel, and Xu, Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk, 2000 – 50 stocks
Alexeev and Tapon, Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets, 2014 – 110 stocks
Thousands of years and tens of thousands of pages of research place the number between 7 and 110.
This is unfortunately not what we see when reviewing investment portfolios and providing second opinions for families who are not yet clients. We routinely find they own thousands of stocks. In a recent review[3] we discovered 4,005 stock positions[4] in a single account. This “over diversification” arises from owning multiple investment products like mutual funds, unit investment trusts, variable annuities, and exchange traded funds. Owning more and more individual investments [beyond a point] does very little to reduce the volatility of an investment portfolio, but it does increase the complexity and cost while reducing transparency.
We prefer a disciplined investment process centered on a simple tenant put forth by Peter Lynch, “Know what you own and why you own it.” It is improbable, if not impossible, for someone or a group to know 4,005 positions.
The number of investments in a portfolio will vary based on each client and their unique circumstances. We do and will continue to make selective use of investment products, primarily exchange traded funds (ETFs), to gain broad access to certain sectors or markets.
Please let me know if you have questions about Easter basket selection, what you own and why you own it, or anything else on your mind.
My Best,
Ryan
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
[1] Parents intervened to return the eggs to the little girl.
[2] Modern Portfolio Theory. Sourced from - http://www.investopedia.com/terms/m/modernportfoliotheory.asp.
[3] Morningstar Snapshot and Intersections reports were used in the analysis.
[4] More than one mutual fund owned the same stock creating multiple positions in the same stock.