Diversification is usually thought of as a way to reduce risk, so that’s where I’ll begin. At its heart it’s a pretty simple concept and one with which you’re probably already familiar, but the basics are important. I would say that at least 80% of your investment results will come from a dedicated and consistent application of the basics, and only 20% from anything that looks even remotely clever.
But back to that question: Just how many different shares should you hold in your portfolio?
Diversification by numbers
The most basic kind of diversification is where you put money into many different companies rather than just one. Diversifying into many companies is sensible because the stock market and the future are uncertain and putting all your eggs in one (or just a few) basket(s) really is a bad idea for most people most of the time.
Opinions vary on this question of how many, but I prefer to stick within Ben Graham’s guidelines, where he said:
“There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty”
My personal preference is to hold more rather than less, so currently I target 30 stocks. When I started out as a stock picker I targeted just 10 holdings because I wanted to concentrate on my “best ideas”. I also wanted to research the stocks deeply and that requires time, so owning less stocks left me time to have a life.
However, over the years I have gradually moved to a less concentrated portfolio.
Diversify so that you can sleep at night
I moved to 30 holdings partly because I didn’t feel comfortable with so much money invested into each idea. If you hold 10 stocks the starting position size is 10%, but it can easily reach 20% if a particular investment does really well. 20% in one company makes me very uncomfortable, especially when that company’s shares could halve in value, which would cost the portfolio 10% from just that one investment.
With 10% or more in one company I tend to get nervous. I’ll start watching the news for that company and when some bad news comes out (trust me – every company gets bad press at some point whether it deserves it or not) I’m much more likely to make an emotionally driven, low quality investment decision.
I don’t want to make emotionally driven, low quality investment decisions and I don’t want to be stressed out by my investments; I want to enjoy the process, so that’s why I switched to holding more stocks with less money in each one. If I hold 30 stocks then I invest only slightly more than 3% of the portfolio into each, and if one of them doubles then it’s still only 6% or 7% of the total amount.
Diversify to spend less time on your investments
Somewhat surprisingly, diversification creates a paradox. The paradox of diversification is that the amount of research an investor needs to do will go down as the number of companies in the portfolio goes up.
That may seem odd, but think about it like this:
If you had to put all your money into one company, how much research would you do before investing? A lot, of course. Once you’d invested, how much time would you spend monitoring that company so that you knew exactly what was going on? You’d probably spend quite a bit of time keeping up to date – I know I would.
What if, instead of investing in just one company, you invested in a FTSE 100 tracker? This tracker holds 100 companies which is a lot; it’s far too many to keep an eye on in any detail. So how many people who invest in FTSE 100 trackers know much about the companies that they’re invested in? How many could name even half the companies in their fund? I guess the answer would be about zero.
The paradox of diversification holds because companies, in aggregate, just tend to grow over time at or above the rate of inflation. As a group they also pay a consistent and growing dividend, which is partly why passive investing is hard to beat. But when you narrow your list down to one or two companies (or five or even ten), the odds of a massive blowup become significant, which is why a concentrated portfolio takes a lot more work than a diversified one.
When I say that I hold 30 companies some people are surprised and comment on how much time it must take me to keep track of them all. But I usually point out that the DOW 30 also has 30 companies in it and most people who track the DOW index do so for decades and don’t even know half of the companies in that index.
I also found that very deep research didn’t seem to add much value (at least for me) compared to just applying a few basic steps. These basic steps are applied with fanatic discipline, but they are still basic and far less time consuming than very deep research (or to paraphrase Ben Graham – I don’t bother counting every last bathtub that comes out of the factory). So by focusing on the few things that really matter I can hold more stocks but spend less time researching them.
The limits of diversification
I like wide diversification, but I wouldn’t want to own everything in the FTSE 100. After all, you can’t beat the market if you are the market, so some concentration is required.
Another issue is costs; the more stocks you own the higher your trading costs are likely to be.
If you have £50,000 to invest and you hold each company for 1 year (although 1 year is closer to speculation than investing, so this is just for example), then a portfolio of 100 companies will have just £500 in each company. That may sound like a lot but each trade costs around £10 and so the act of buying and selling each company generates £20 of costs (not to mention stamp duty and the bid/ask spread), which is 4% of the total. A 4% per year drag on returns is enough to pretty much wipe out any returns from the stock market after inflation.
Sticking with 20 holdings instead of 100 would increase the size of each investment to £2,500, and so the £20 cost of buying and selling would be just 0.8%, leaving most of your inflation-adjusted returns intact. A longer holding period would reduce costs even further.
In general, more diversification is better, but only to the point where the benefits (lower risk, lower stress, lower effort) are outweighed by the costs (constraints on out-performance and trading costs). For me that balance is best struck with around 30 holdings.