Diversification: You Don't Have to Live by Wall Street's Rules

by: John Tobey, CFA

In my last article, I said Boeing (NYSE:BA), Caterpillar (NYSE:CAT), Intel (NASDAQ:INTC) and Walmart (NYSE:WMT) made up a nice mini-portfolio. But do they? Isn’t a portfolio of only four holdings way too concentrated? After all, the saying, “Don’t put all your eggs in one basket,” means one should diversify to avoid the risk of a big loss.

Wall Street endorses that approach and advises you to do the same, but you don’t have to follow their lead. There are strong business reasons for diversifying broadly, and they are powerful drivers to Wall Street. But to investors, the reasons are immaterial, so the focus can be exclusively on investment performance.

Wall Street (meaning most investment professionals and organizations) adopt a policy of diversifying broadly because:

  1. There is less of a chance of negative performance surprise. With investors looking at portfolio / fund returns relative to indexes, a better business approach is to stay close to the market. It’s been shown that it’s easier to keep investors in place with mediocre returns than to have superior long-term returns that entail peaks and valleys along the way. (Because many investors act on past performance, they leave if a fund hits a period of under-performance. And that’s bad news for the fund, because the rule of thumb is that once an investor leaves, it takes at least five years for them to consider coming back.)
  2. A short list of holdings becomes more difficult to manage as assets grow larger. The sheer size of the orders can make trading at attractive prices challenging. There are two solutions: Close the fund to new flows (occasionally done) or broaden the number of securities held (often done).

This isn’t to say all investment managers live by these same rules. I have hired and worked with many who were strictly performance driven and held more concentrated portfolios.

That approach is represented by another popular saying: “Put your eggs in one basket, then watch the basket carefully.” The idea is that the more securities owned, the harder it is to find really good ones – the more likely the end result is a ho-hum portfolio. Therefore, the advice is to stick with the few stocks we know and like best.

Note: This strategy does not mean an investor’s entire allocation to stocks is in only a few holdings. Rather, it refers just to the stocks one manager – or we – has / have chosen; that we limit the number to those we really understand. Index funds and / or actively managed portfolios run by others can make up the balance of the total stock allocation.

Now back to the question as to whether four holdings can really be considered a diversified portfolio. The answer is yes, it can, if the companies are different from one another – e.g., different economic sectors, industries, customers, manufacturing processes, locations, etc. The reason for this need is that investment diversification benefits flow from dissimilar return patterns – e.g., one stock running, another walking, another sitting, and another drifting backwards, all at the same time. Overall, the portfolio return is less volatile than any one of the individual holdings.

It’s fairly clear that Boeing, Caterpillar, Intel and Walmart are dissimilar. But how much variability reduction can we expect from only these four? Mathematically, the amount of non-market volatility can be reduced by about one-half.

For most stocks, diversification primarily reduces non-market volatility. The stock market, itself, exerts a force on all stocks, as we have seen in recent markets, and holding more stocks does not reduce that effect.

The following graph shows the maximum amount of diversification effect strictly by the number of holdings in a portfolio. (The calculation is: Portfolio variability = Stock variability divided by the square root of the number of holdings.) That mouthful means four different holdings can reduce the variability by one-half.

Click to enlarge

Note that it takes only a few holdings to capture a sizable amount of the diversification effect. As described in the graph, if the stocks are not truly independent of one another or their variabilities are different, the diversification effect will be less. Clearly, meeting those conditions becomes more difficult as more holdings are added to a portfolio.

So, a few holdings, like the four I have used as examples, can accomplish much of the desired diversification effect.

Disclosure: No positions