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Summary

  • There is no perfect diversification strategy that universally applies to everyone.
  • What's best for you relates to what your specific investment objectives are, as well as how much risk you are willing to assume.
  • 20 names captures most of the benefit of diversification.
  • When considering how many stocks to include in your equity portfolios, less is more.

Introduction

First and foremost, it should be clear that this series of articles relates solely to the equity portion of a retirement portfolio. Consequently, the focus has been on designing and constructing the stock portion of a retiree's portfolio. Questions such as what other asset classes and/or the appropriate diversification among other asset classes are not relevant to the subject matter. Therefore, this Part 3 will deal with various diversification options and theories on how to diversify a stock portfolio that's perfect for you.

Moreover, it should be understood that there is no perfect diversification strategy that universally applies to everyone. Some individual investors will be more comfortable with a highly concentrated stock portfolio, while others might be more comfortable with broader diversification. Contributing factors to what's best for you relates to what your specific investment objectives are, as well as how much risk you are willing to assume. Furthermore, there are underlying principles that will support a concentrated portfolio over broad diversification, and vice versa. My objective with this article will be to highlight some of the more common equity diversification theories.

On the other hand, there are almost an infinite number of gradations that apply to both a concentrated portfolio and a broadly diversified portfolio. Therefore, another one of my primary objectives is to underscore the primary principles of diversification and how they relate to generating returns and to mitigating risk. My hope is that if I can successfully articulate how these principles relate to return and risk, the reader will be better informed and prepared to apply these diversification strategies and principles to their own unique goals and objectives.

Diversification Versus Concentration

The proper number of stocks to include in a portfolio has been a subject of much debate and disagreement. Moreover, there are academic studies that portend to support and prove both sides of the argument. For example, a widely cited study by Bloomfield, Leftwich, and Long (1977) suggested that a portfolio of 20 stocks captures the majority of the benefit that diversification offers. In contrast, academics from renowned schools, such as Harvard, Princeton, and the University of Texas argue that investors need to own as many as 50 individual stocks.

The venerable Ben Graham suggested holding 10 to 30 stocks. Charlie Munger and partner Warren Buffett are on record of suggesting only 5 to 10 individual stocks as the optimum number. Additionally, I have read that John Keynes preferred only 2 to 3, and Seth Klarman liked 10 to 15. Then, of course, there are the indexers that believe in owning hundreds of stocks. Since all of these are credible sources, whom are we to believe? From my perspective, all or any of them, it all depends on your tolerance for risk and investment objective.

Since Part 1 and Part 2 of this series focused on the recommendations of Peter Lynch and his best-selling book "One Up On Wall Street," I feel it is only appropriate to follow suit here and report what he had to say on the subject of diversification in chapter 16 titled "Designing A Portfolio." Peter had several comments and suggestions that I found interesting, as the following excerpts reveal:

On page 240, Peter said:

"it's only by sticking to a strategy through good years and bad that you maximize your long-term gains."

Later, on the same page, he added:

"For all the time and effort it takes to choose individual stocks, there ought to be some extra gain from it."

On page 241, he provided this tidbit of wisdom:

"Here's another place where the person who holds on to stocks is far ahead of the person who frequently trades in and out."

Then, on page 242, he offers this:

"The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis. In my view it's best to own as many stocks as there are situations in which: (A) you've got an edge; and (B) you've uncovered an exciting prospect that passes all the tests of research. Maybe that's a single stock, or maybe it's a dozen stocks….. There's no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors. That said, it isn't safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I'd be comfortable owning between 3 and 10 stocks."

Of course, the reader should keep in mind that the above words are from a man that owned 1,400 stocks in the mutual fund he managed. However, in the book, he also reported that half of all his funds' assets were invested in 100 stocks, and two-thirds of his fund in 200 stocks, and he added that 1% of his money was spread among 500 secondary opportunities that he was monitoring periodically. However, the challenge of managing a portfolio containing billions of dollars is a far different task than faced by the average retiree's personal portfolio.

Six Primary Categories According To Peter Lynch

Peter Lynch offered much more advice about diversification in chapter 16 of "One Up On Wall Street," and it's a book that I highly suggest to anyone that invests in common stocks. However, in order to keep this article consistent with what was written in the previous installments, I offer the following excerpts from the section he titled "Spreading It Around." For added perspective, I will include an earnings and price-correlated F.A.S.T. Graphs™ and performance report below each of Peter's comments on each of the six categories he suggested. To get the most of this exercise, I propose that you focus on the earnings growth rate (yellow circle) on each earnings and price-correlated graph, and how the capital appreciation component correlates (orange circle - yellow highlight):

"Spreading your money among several categories of stocks is another way to minimize downside risk, as discussed in Chapter 3. Assuming that you've done all the proper research and have bought companies that are fairly priced, then you've already minimized the risk to an important degree, but beyond that, it's worth considering the following:

Slow growers are low risk low gain…. "

AT&T Inc. (NYSE:T)

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"Stalwarts are low risk, moderate gain…."

Note: The stalwart Coca-Cola (NYSE:KO) historically commands a premium valuation (the dark blue line) to its earnings justified valuation line (the orange line). However, the premium valuation is consistently applied. Therefore, capital appreciation correlates to earnings growth rate when purchased at the premium valuation.

The Coca-Cola Company (KO)

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"Cyclicals may be low risk and high gain or high risk and low gain, depending on how adept you are at anticipating cycles…."

Caterpillar Inc. (NYSE:CAT)

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"Meanwhile, additional ten baggers are likely to come from fast growers or from turnarounds -- both high risk, high gain categories…"

I will provide a sample fast-grower later. However, Ann Inc. (NYSE:ANN) illustrates how profitable a turnaround can be if you can determine precisely when it will occur.

Ann Inc.

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Coming out of the Great Recession of 2008, Ann Inc. turned its business around and generated powerful earnings growth.

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Performance since 12/31/2008 was beyond exceptional. However, it would take great investor courage and perhaps insight to successfully harvest these results.

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"…. Asset plays are low risk and high gain if you're sure of the value of the assets…"

Harvest Natural Resources Inc. (NYSE:HNR)

Harvest Natural Resources Inc. has a very poor earnings record and a very volatile and erratic stock price history. Consequently, performance based on earnings is unacceptable.

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However, look at its assets per share (atps) almost 4 times the company's stock value. This begs the question; could you be patient enough to wait for those assets to be unlocked?

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"There's no pat way to quantify these risks and rewards, but in designing your portfolio you might throw in a couple of stalwarts just to moderate the thrills and chills of owning four fast growers and four turnarounds. Again, the key is knowledgeable buying."

Note: The reader might additionally benefit from revisiting the earnings and price-correlated F.A.S.T. Graphs™ and associated performance reports found in Part 2 of this series. A careful examination of the business results provided by each of the categories and how those business results generated returns will provide graphic and vivid evidence of the validity of Peter Lynch's summary of each of the categories referenced in the previous paragraph.

Diversification Strategies Based On Individual Objectives

I believe there are many great investing lessons that we can all learn through a careful consideration of what was suggested by many of the money masters referenced above. More importantly, I contend that there exists less conflict between their disparate views than meets the eye. More clearly stated, I think all of the advice above is both correct and incorrect, depending on each individual's objectives and risk tolerances. My point being that various diversification strategies become proper based on whether your goal is maximum total return or maximum safety.

If your primary objective is maximum total return, then I would argue that less diversification is better than more. If your primary objective is safety, then I would argue that more diversification is better than less. My arguments are based on understanding some of the nuances underpinning the major underlying principles of diversification that I alluded to earlier in the article. Although I cannot cover them all, what follows is my attempt to cover some of the most important underlying principles and how they apply to constructing a portfolio with just the right amount of diversification, depending on your objectives.

Diversification for Maximum Total Return

If your objective is to achieve the highest total return possible, it is only prudent to simultaneously recognize that you must take higher risk. At first blush, you might logically conclude that a maximum total return portfolio must therefore be more diversified because of this risk. However, I believe that logic would be flawed for the following reasons. To my way of thinking, maximum total return also indicates significantly above-average returns.

Therefore, the maximum total return investor is faced with at least two obstacles. First, high total return is associated with companies generating high levels of earnings growth. There simply are not that many stocks that can sustain earnings growth at 15%, 20% or greater. Second, it is difficult to find high earnings growth companies that can be purchased at sensible valuations. Consequently, I believe that a well-constructed high total return portfolio implies less diversification opportunities, not more. Therefore, extensive research and monitoring, coupled with only being willing to invest when sound valuation is present become your best risk-control mechanisms.

Fast-Growers Are Rare

If maximum total return is your objective, then I believe that fast-growers are your best option. Peter Lynch was a growth investor at heart, and this was his favorite category to invest in. However, the principle that truly exceptional fast-growers are rare is undeniable. Even considering that fast-growers possess the highest risk, I would support being very selective with this category. Therefore, I would suggest constructing a portfolio of fast-growers containing only 10 individual stocks, and certainly no more than 15.

However, I would also suggest that each of these selections be deeply researched and continuously monitored. When the risk is high, the necessity to thoroughly know and understand the company is intensified. Fast-growers unequivocally possess higher risk, so if you invest in them, you better know them well. I believe it's impractical, if not impossible, to research and monitor more than 10 companies as deeply as a fast-grower requires.

Therefore, I suggest lowering the risk of investing in fast-growers with profound knowledge. Since they are also rare, finding more than 10 truly good ones that are simultaneously fairly valued would be hard to do. For the reader that's interested in this category, I offer the following example that I believe is both fairly valued today and appears to possess the prospects for future growth that would warrant deeper research.

Catamaran Corporation (NASDAQ:CTRX)

Catamaran Corporation provides pharmacy benefit management (PBM) services and healthcare information technology solutions to the healthcare benefit management industry. The company conducts its business primarily in the United States, with some additional business in Canada.

Catamaran Corporation has a consistent and high record of earnings growth since its public debut in June 2006. Price has tracked earnings, and recently appears fairly valued, based on its historical earnings growth rate record.

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Historical performance closely correlates to the company's earnings growth rate for this fast-grower.

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Moreover, as previously suggested, high growth is hard to sustain. Consensus estimates for future growth are still high, at over 23% per annum. However, this is significantly below its historical growth rate achievement. Nevertheless, this fast-grower appears reasonably valued, based on future growth expectations. It's important to always remember that we invest in the future, not the past.

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Diversification for an Income Objective

Investors interested in income will have more choices at their disposal than pure growth investors. Therefore, income investors will also have more opportunities for broader diversification. For example, fellow Seeking Alpha author David Fish, in his most recent article, reported that his Dividend Champions, Contenders, and Challengers grew to 526 companies. These CCC companies all have legacies of increasing dividends streaks spanning from 5 to 25 years or more.

I feel that most of these are the crème de la crème of dividend growth stocks, but will add that there are thousands of other dividend-paying stocks to choose from. Therefore, investors seeking stocks that pay dividends will have ample opportunities to diversify their portfolios more broadly. On the other hand, since most Dividend Champions with 25 or more straight years of paying higher dividends now total 105 names, most of them would also qualify under Peter Lynch's definition of a stalwart. Consequently, the argument could be made that massive diversification is not necessary when investing in such high-quality companies. An added benefit might be that due to their high quality, they might also require less research and monitoring.

As a result, I am comfortable making the argument that even the dividend growth investor might consider limiting their portfolio names to 30 or less. And, if you buy the argument that 20 names capture most of the benefit of diversification, it might make sense to limit a dividend growth portfolio to that number. However, when building a portfolio that selectively, the importance of valuation cannot be stressed enough. Investing in common stocks when valuation is sound is a powerful reducer of risk.

Additionally, investors seeking high levels of income can also consider REITs and MLPs. These equity classes not only offer additional diversification opportunities, they typically offer higher current yields as well. Consequently, they can be selectively integrated into a dividend income portfolio in order to provide higher yield and broader diversification without going overboard.

Sample - Fairly Valued Dividend Champion

Stanley Black & Decker Inc. (NYSE:SWK)

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Summary and Conclusions

When considering how many stocks to include in your equity portfolios, I contend that less is more. If you are so afraid of risk that you feel compelled to own more than 30 stocks in your portfolio, then I agree with investing greats such as Charlie Munger, that you should consider indexing. In other words, once you get above 30 names, I believe you begin to dilute the benefit that diversification provides. Furthermore, with every additional name that you add to your portfolio, you move closer to attaining average results. Therefore, you might as well invest in the averages through buying an index fund.

On the other hand, if above-average return is your objective, I suggest investing in fewer names. However, and at the same time, I suggest extensive research, coupled with a high commitment to sound valuation. If you want to be better than average, you must be willing to do what's necessary in order to accomplish it. Personally, for the reasons presented in this article and others, I favor concentration over broad diversification. However, I acknowledge that this only makes sense for those investors endeavoring to do better than average and willing to put in the necessary effort.

I will close this article with a quote from Philip Fisher and his book "Common Stocks and Uncommon Profits." I consider Philip Fisher one of my most revered teachers, and consider him one of the greatest investment theorists that ever lived:

"Don't overstress diversification. No investment principle is more widely acclaimed than diversification. Be that as it may, there is very little chance of the average investor being influenced to practice insufficient diversification. The horrors of what can happen to those who "put all their eggs in one basket" are two constantly being expounded.

Too few people, however, give sufficient thought to the evils of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them.

Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having an adequate diversification."

As I alluded to earlier, there are additional approaches to diversification that investors might consider. For example, the Peter Lynch concept modified to smaller portfolios may consider a strategy of putting half of their money into their top 10 best selections, and then diversifying the other half of their money into a larger universe of, say 50. This strategy would employ both concentration and broad diversification. Of course, there are numerous variations of how a strategy like this could be implemented. However, at the end of the day, how much you diversify might be more relevant to whether you are most concerned with avoiding risk or most concerned with making a great deal of money.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Source: Diversifying The Perfect Retirement Portfolio - Here's How: Part 3