Most investors don’t know anything more about diversification than you “shouldn’t put all your eggs in one basket” [but] spending some time trying to understand the ways you might be shooting yourself in the foot could seriously enhance your portfolio returns and stop catastrophic risk. [There are some advantages to diversification if you REALLY know what you are doing but the shortcomings can go a long way towards killing your portfolio returns. In this article we identify what they are and how best to avoid them.] Words: 1055
So says Edward Croft (www.stockopedia.co.uk) in edited excerpts from his original article*.
Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) has edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) below for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.
Croft goes on to say, in part:
5 Ways Diversification Can Kill Your Portfolio Returns
1. You own too many stocks and the costs are crippling you
In 1977 Elton and Gruber published a landmark research note that showed that:
- most of the gains to be had from diversification come from adding just the first few stocks
- adding 4 more stocks to a 1 stock portfolio gives you 71% of the benefits of diversification of owning the whole market
- owning just 15 stocks brings about 87% of the benefits of a fully diversified portfolio
- the more stocks an investor owns, the more likely they are to bleed away performance in higher transaction fees as the relative size of their orders are reduced in relation to the fixed costs of trading. These higher transaction costs significantly reduce long term returns especially in smaller portfolio sizes.
2. You own too few stocks and you are missing the winners[On the other hand,] William Bernstein, the renowned financial theorist, hit out at this ’15 stock diversification myth’ with a smartly argued case that:
- while investors who only own a few stocks may have reduced their portfolio volatility the real risk they face is of significantly underperforming the market by missing the winners.
- much of the overall market return comes down to a few ‘super stocks’ like Dell Computer in the 1990s which grew by 550 times. “If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market”.
- As the odds of owning one of these super-stocks was only one in six Bernstein argued that you could only mitigate the risk of underperformance by owning the entire market!
Of course, intuitively, there comes a point when, by owning too many stocks, the impact of finding a winner has a negligible effect on your portfolio which rather ruins the joy of it. In a 30 stock portfolio any stock that doubles will only add 3.33% in performance which is frankly pretty dull. Peter Lynch once mused “It only takes a handful of big winners to make a lifetime of investing worthwhile” – just make sure they have that impact!
3. You just think you are adequately diversified
Portfolio Theory has shown that there’s an ideal level of diversification between 2 stocks which both minimises risk and maximises return – ideally you want to own stocks that zig while others zag to achieve this. This may be easy in theory but it seems to be way beyond the ken of most investors.
A 1990’s study of study of 60,000 private investor portfolios by Kumar and Goetzmann at one of the U.S.’s biggest discount brokerages found that:
- investors on average owned only 4 stocks. Not only that but these stocks had price movements that were highly correlated. As a result their portfolios were almost as risky as the assets held within them completely negating the benefits of diversification!
- Higher portfolio volatility puts far greater emotional pressure on less sophisticated investors contributing to poorer decision making and worse returns. The average portfolio in the study underperformed the market by between 0.5% and over 4% annually!
4. You’ve bought funds but are getting killed by hidden costs
Few investors in mutual funds understand that:
- there are hidden costs on top of the stated expense ratios that can reduce your funds returns by as much as another 3% per year from your fund returns!…
If Index Tracker funds have been shown to beat 75% of actively managed funds over the long term mainly due to a massive reduction in these costs – why take the risk? [Read: Don’t Invest in Mutual Funds! Here’s Why]
5. Your foreign content isn’t performing much differently than your domestic stocks
Once upon a time investing in foreign markets and odd commodities brought a good hedge to portfolios as these assets returns were uncorrelated with local stock markets. In the last 20 years, however, financial innovation has marketed ETFs, hedge funds and structured products to a globalizing financial customer base allowing almost push button exposure to exotic asset classes and advanced alpha extraction techniques.
The net effect is that:
- different markets and asset classes now regularly trade as baskets and the correlations between them have risen dramatically [and, as such], the benefits of diversification are much smaller in the global marketplace than ever before.
Give this environment a bad market like 2008 and financial contagion can spread like wildfire, sparing almost no asset class, ruining portfolio returns and striking a spear into the heart of diversification theory.
It may be that the only real hedge these days is a completely new asset class – volatility itself. A recent study showed that:
- adding a 10% position of the volatility index (VIX) to an equity portfolio outperformed the market index while reducing risk by 25%!
How to avoid poor diversification
- own a few global tracker funds in varying asset classes while hedging with the VIX can spare you fees and the risk of under-performance while bringing volatility protection,
- allowing a minority allocation to your own 5 to 8 best stock picks will possibly save your sanity from complete boredom while just possibly bringing the outperformance you hope for.
Warren Buffett might caution that ‘diversification is a hedge for ignorance‘ but the smartest move of all may be to accept that you just aren’t that smart!
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