Diversify your portfolio, up to a point….

leesoonkie
Nov 4, 2017
3 min read

While most know the benefits of diversification in a portfolio, not many are aware of the limits of diversification.

In his seminal work, A Random Walk Down Wall Street, Burton Malkiel pointed out the diminishing benefits of diversification. As the number of stocks increase, the marginal benefit of a reduction in risk becomes lower until it tapers off as shown in the diagram.

This is also repeated in modern portfolio theory. For e.g. in Edwin J. Elton and Martin J. Gruber's Modern Portfolio Theory and Investment Analysis, they concluded that a portfolio of 20 stocks would reduce risk to about 20%, close to the market risk of 19.2%. The reduction from a single stock risk of 49.2% to a 20 stock risk of 20% is startling. However, increasing the number of stocks from 20 to say 1,000 will only reduce the portfolio's risk by about 0.8%.

Some have challenged the low number of stocks, in particular Sur and Price suggests a larger number using a different measure of risk (Coeffcient of Determination or R-Squared). Regardless of the risk measure used, there does seem to be a diminishing return in stock diversification which parallels the law of diminishing returns in economics.

The question then arises, why do so many fund managers regularly have more than 100 stocks in their portfolio? To be fair the fund may cover various markets, China, Japan, Hong Kong, South East Asia etc. The cynical would of course say that most of them like a big portfolio as the chance of a divergent move from the market becomes markedly less. However with the fees they charge they are more likely to underperform the index . :) :) :)

The idea of a finite number of stocks to spread your risk is comforting. Most of us would be able to keep track of say 25 stocks, reading up research reports, quarterly announcements etc. Beyond that we tend to skim through and thus miss some details. After all a 25 stock portfolio means 100 quarterly announcements to read, add the number of research reports churned out and news you can just about keep up.

Diversification does not eliminate risks. Stock selection and regular re-balancing is still important. Some industries are in a cyclical downturn some recovering. New technologies and industries emerge and new IPOs come to the market now and then. You always have to consider adding them to your portfolio. It is disconcerting to find out after a few years that while your portfolio risk is low the stocks you picked turned out to be dogs. Short of owning the whole market financial risks cannot be eliminated completely.

It is also important to note what diversification is. Having say UOB in your portfolio and adding OCBC or DBS in an attempt to diversify does not help at all as bank stocks tend to move together over a period of time. We need to diversify across industries, size and even countries. Obviously we try to choose the outperformers in each sector. This is simpler said then done.

At a higher macro level there is also a need for asset diversification. Having all your monies tied up in stocks leaves you heavily exposed to a downturn. With the world increasingly connected, a sharp fall in New York spreads worldwide. We also need to consider other asset classes such as bonds, properties and even alternative assets such as commodities.

A truly independent financial advisor will help in managing your wealth. Independent in the sense that he, or she, is not motivated for pushing products from his bank or security house. This remains largely a myth now for how else are financial advisors paid if not through “commissions”?

At the end of the day, it might be better to brush up a bit on your finance skills. The smooth talking financial advisor still needs to make a sale to get his bonus.