The Right Number of Stocks for Portfolio Diversification

By July 12, 2018 March 25th, 2019 Insights - Financial adviser

When it comes to constructing a direct equities portfolio a common dilemma faced by investors is the decision around how many stocks to include. Too many can make a portfolio harder to monitor, can increase transaction costs and can often be interpreted as a lack of conviction. Too little and a portfolio risks being over-concentrated, unnecessarily volatile and can contain risks that could easily have addressed via diversification.

As with most things in life, the first thing to consider is what are you are actually trying to achieve. If you are looking to track and potentially outperform a specific benchmark index, then a larger number of stocks is generally going to be required. However, if you are less “benchmark aware” and are more focused on simply reducing volatility whilst maintaining conviction on your stock views, then a smaller number will be needed.

Putting some Numbers Around It

Academic studies² have shown that if your aim is simply to reduce risk, measured in terms of portfolio volatility, then holding as little as 20-30 equally weighted positions can provide 90% of the diversification benefit as owning the whole index. Diversification beyond that number only provides a limited and diminishing level of benefit, as shown in the chart below:

 

 

On the other hand, if your portfolio is heavily benchmark aware it will take a much larger number of equally weighted holdings to address your “risk”. This is because risk takes on an additional dimension. Not only are you trying to reduce overall volatility, but you will also want to manage the performance risk relative to the index itself. A study by Surz & Price shows that upwards of 60 equally weighted holdings are needed to significantly reduce risk that incorporates “tracking error”. The cost of course of holding such a large number of stocks is that it inevitably means including companies over which you have much less conviction!

True Diversification involves more than a min number of holdings

While the number of holdings undoubtedly impacts portfolio risk, true diversification is more about how the holdings within your portfolio behave relative to each other. For example, constructing a portfolio that consists of the 20 largest Australian “blue chip” stocks weighted according to their market cap (size) may seem like a sound investment strategy and one that would help address tracking risk. However in Australia, this would mean allocating over 48% of your portfolio to the Financials sector, with less than 18% in total allocated across important sectors such as Industrials, Healthcare, Energy and Consumer Discretionary companies. The graph below shows how a portfolio constructed this way at the start of 2017 would have performed vs the ASX200 Index over the period since:

 

 

It goes without saying that companies within the same sector are more highly correlated than those that are not. The impact of the Royal Commission on the Financials sector being a case in point! In this case not only did the “top 20” portfolio significantly underperform over this period, but it also exhibited considerably more volatility.

A number of considerations

In summary, diversification is an extremely important ingredient when constructing a direct equities portfolio. It is no accident that it is known colloquially as the only “free lunch” in finance. However, it’s important to be aware that there are a number of factors which play a role in diversification, from the number of holdings to the correlation of the individual assets themselves. This is where professional investment tools that enable investors to understand and quantify these sources of portfolio risk and expected return can play such an important role. Finally, it is important to consider the objective of the portfolio itself and the investor’s tolerance for volatility, both in absolute terms and in reference to the index benchmark.

References

  1. Surz, R, Price, M, 2000, ‘The Truth About Diversification by the Numbers’, The Journal of Investing, Winter 2000.
  2. Vitali A, Francis T, 2012, ‘Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets’, SSRN, November 29, 2012

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.