Diversification: When Less is More & More is Less
If you put your money to work in stock funds vs. stocks, the promise of diversification no doubt played a big part in your decision.
That’s sound reasoning, as far as it goes. By spreading your capital among many stocks, equity funds offer the prospect of appreciating like stocks without the risk of investing in individual publicly traded companies.
Many people, however, don’t fully grasp the nature of diversification. That failure can mislead stock investors to overestimate the the risk-abating benefit of diversification while misleading fund investors to underestimate it.
The yardstick for risk is volatility, the degree to which a portfolio’s returns depart from some desired or average return. Loosely speaking, the more a portfolio diversifies its holdings among an ever-larger sampling of stocks, the less its returns owe to any single holding. As a result, more diversification means less volatility.
However, diversification is subject to a law of diminishing returns. In other words, the more stocks you add to a portfolio, the less diversification you get from each additional position.
If that sounds confusing, look at it this way: Let’s say you invest $50,000 in a single stock. Later you decide that putting all that money into just one stock leaves you too vulnerable. If trouble hit the underlying company, you could lose a big part of your capital in a flash. So you sell half your shares and invest the money in the stock of a second company.
Right away, you have cut your company-specific risk in half. Now, the volatility of your portfolio won’t drop by half because only part of a stock’s risk is unique to itself alone. Both your stocks probably share some market risk. And if the stocks were issued by companies in the same industry or sector, they might share still more risk. But still, you’ve significantly reduced the risk to your portfolio insofar as you’ve halved your exposure to any single company.
Now let’s say you decide to diversify further and spread your capital in equal portions among three different stocks, then among four stocks, then five, and finally six. Notice how your company-specific exposure declines by a smaller amount with each added level of diversification.
One stock means exposing 100% to one stock. Adding a second stock reduces your company-specific exposure 50% of your capital. Going from 100% exposure to 50% exposure represents a decline of 50 percentage points.
Going from two stocks (50% exposure) to three stocks (about 33% exposure) produces a decline of 17 percentage points. Adding a fourth stock cuts your company-specific exposure to 25%, a decline of eight percentage points.
Notice how with each added position, one reduces one’s exposure less. This hold important significance for the trader or investor in individual stocks. By the time an average portfolio has diversified among a dozen or so stocks, any number of academic studies show that taking on more positions produces negligible reductions in the average portfolio’s volatility.
This has led some stock investors to take an unjustifiable security in diversification resulting from a dozen positions. In fact, though, while the average portfolio with say, a dozen stocks, has close to the same volatility as an average portfolio with hundreds of stocks, many of us won’t have an “average” portfolio.
A study by Gerald Newbould and Percy Poon, two finance professors at the University of Nevada at Las Vegas, looked at how the volatilities of sets of portfolios with the same number of, but different, stocks varied around the average of the group. Until one reached about 40 stocks, individual portfolio volatility still varied widely around the mean. And 40 stocks is well above the number the vast majority of traders or investors can actively keep track of.
The implication for the stock investor is that diversification only protects you from company-specific risk so far. You also must employ loss-cutting tactics in the form of stop-loss prices in addition to diversification to guard against catastrophic declines in any one position.
On the other hand, fund investors often underestimate the power of diversification. Once you’re in a diversified fund (as opposed to a sector fund), your capital is as diversified as it can be from company-specific risk.
Yet fund investors often make the mistake of buying shares in far more diversified funds than they. In normal times, no more three mutual funds will do the trick for the investor who looks to diversify across different investing strategies — such as value vs. growth — and industry sectors.
It can’t hurt, though, to keep an eye on the periodic reports of your chosen funds’ holdings. In extremely divergent markets in which a few leaders are hogging all the gains, diversified fund managers come under the temptation, if not outright pressure, to drift from their stated investment objectives and load up on the few stocks that are working. Consequently, you might own several funds, with different objectives, such as value, growth and growth & income, yet still have much more of your money exposed to a few stocks that you realize.
Newbould believes that the 1999-2000 stampede into New Economy tech stocks created that special situation.
“What worries me right now is, how many mutual funds are in technology,” Newbould said. “To get their performance, they put their money into technology funds. You’ve even got bond funds holding technology stocks. Even investor who owns half a dozen mutual funds might still find 5% to 10% of his money is in the same stock. Every manager is looking at his investment constraints and seeing how much he can put in tech stocks. Otherwise, his performance will be terrible and his bonus will be nonexistent.”