The 5 Ways Diversification Can Kill Your Portfolio Returns

20th Jan '12 by Edward Croft

5 comments 11725 reads

Given that the law of diversification is about as close as one can find to a consensus belief amongst investors your portfolio is most likely to have at least a few stocks in it. But what if I was to tell you that the level and style of your diversification could be putting your capital significantly at risk?

The truth is that most investors don't know anything more about diversification than you "shouldn't put all your eggs in one basket". 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. But frankly who would want to trudge through all those finance journals?

Well, err… we did and here's what we've found…

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. Even owning just 15 stocks brings about 87% of the benefits of a fully diversified portfolio.

Not only that but 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.

So if your stockbroker has you in a portfolio of 35 stocks in the name of diversification you can always quote Elton and Gruber while firing him for someone cheaper and (dare I say it) more exciting.

2. You own too few stocks and you are missing the winners

But hold your horses… 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.

Bernstein showed that 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…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Mike Dever

20th Jan '12

Diversification is the one true "Free Lunch" in investing. In my book "Jackass Investing: Don't do it. Profit from it.," I show how a 'truly' diversified portfolio can easily outperform, with less risk, a 'conventionally-diversified' portfolio. In short, if you start by limiting your diversification opportunities to global stocks, bonds and some commodities, you will never be truly diversified. That is why studies like those done by Elton and Gruber and seriously flawed and meaningless.

In my book I replace asset classes with "return drivers" and "trading strategies" (as I point out in the book, asset classes are simply long-only trading strategies that do not attempt to disaggregate their many separate return drivers). Once viewed in this fashion it is easy to create a truly diversified portfolio, rather than one constrained by the shackles of asset classes.

I am pleased to provide you with a link to the chapter describing the use of return drivers in place of asset classes: http://jackassinvesting.com/lookinside/lookinside_chapter_17-77.php,

as well as a link to the book's final chapter, where I present actual model "Free Lunch" portfolios, which can earn greater returns & less risk (compared to a 'conventionally-diversified' portfolio: http://bit.ly/vxDo6v.

harryr

21st Jan '12

You only need 5 or 10 stocks.
You only want to invest in very, very small companies.
You need time, so invest in these when your 20 not 50.
Take a look at my posts on this site under Harryrr
You will see how do do it.
Shares are very easy buy cheap when others will not.
Buying stocks the are down 95% is a good idea
10, 30, or 50 bag and you never need to work again.
Find a company with a market cap under £1M and 3% costs just £30,000.
Roll on ten years and it could grow 100 fold.
Asos did it in under that.
All shares have risk so why on earth to investors buy stocks on a pe of 12 when you should be buying on a pe of one or two?

Daytona

22nd Jan '12

Thought provoking research sources, thanks Ed.

emptyend

23rd Jan '12

It is now some 27 years since I learned at Business School about modern portolio theory - and concluded that a ten stock portfolio was sufficient diversification for my needs in normal circumstances.

As most know, I have been very heavily overweight E&P stocks for the last 12 years or so, having liquidated a 5-year holding of techs to fund the initial investments. I've also been heavily concentrated within that sector....which worked fine for the first 8-9 years and rather less well for the last 3 years or so.

Ex-post I can see that I may have done better holding different stocks (though it would have equally been possible to lose my shirt!). Part of that underperformance arises from unsuccessful exploration efforts (which could, and ex-post should, have been diversified) but another significant chunk of underperformance seems to me to be the result of sentiment, coupled with an increased tendency of risk assets to move together in the so-called "risk-on, risk-off" trade, which has been pervasive over the last couple of years. I suspect that the root of this correlation problem is well-noted here:

But in the last 20 years financial innovation has marketed ETFs, hedge funds and structured products to a globalising 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. Unsurprisingly 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.

I've been noting in various posts over this period (but especially back in 2007/8, as well as more recently) that the investment environment is extremely difficult....and that has certainly been the case. Stock-picking has been extremely difficult to get results from, unless one happened to be owning a stock at the time of a takeover bid or unless one had correctly forecast that the hunt for yield would lead investors to chase dividend-paying stocks. Pretty well everything else has simply got blown around by the risk-on/risk-off trading and it has been very tricky to outperform. Even Andy Brough who runs the Schroeder 250 fund and who had a stonking performance pre-crash has recently been forced to explain why his fund has lost money over the last 5 years (down 30% or so IIRC).

My guess is that this period of risk-on/risk-off correlations may be coming to an end, and that (just perhaps) stock-pickers may do a bit better going forward. I'm starting to dust off my plans for a major change in the way my portfolio is run (having had those plans in what turned out to be cold storage for the last three years) and my guess is that by year-end my portfolio will be more diversified than it has been for many years (maybe 12+ stocks). Between now and then, I'll be hoping that opportunities come along to generate some cash....and that I can find enough interesting places to reinvest. At least the latter looks a more achievable task now than it has done in the recent past.....just need the former to finally fall into place ;-)

davidcecil

When it comes to investing all your research will not protect you from the subseqent actions of the CEO. Fred Goodwin trying a large takeover at the top of the market and Eric Daniels taking similar action while the market was in freefall. On both occasions full support of the directors and major investors qas asked for and given and within days both companies were wiped out

The 5 Ways Diversification can kill your Portfolio Returns

1. You own too many stocks and the costs are crippling you

2. You own too few stocks and you are missing the winners

Unlock the rest of this article with a 14 day trial

About the Author

Edward Croft

5 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...