A few weeks ago I answered the ever-popular question of 'How many stocks should I own?'
I showed you the following chart, which (loosely) demonstrates the idea that the benefits of diversification start to wear off around 30 stocks.
Broadly speaking, diversification is a risk-reduction technique that tries to reduce the random ups and downs of stock prices. That is, it is a strategy to lower risk but because it lowers risk it can lead to better returns over time.
Why 15 ASX stocks is enough (asteRISK)
However, there are a large number of professionals who believe even 30 stocks is far too many.
Let me explain their argument from a few different angles.
Firstly, it makes intuitive sense for you or me to hold less than 30 stocks because it's tough to keep up. I cover stocks for a living but there's no way I could tell you everything there is to know about 30 companies. Heck, if you had 30 children I'd bet you couldn't even tell me the basics, like their dates of birth, middle names and aspirations in life.
Knowing the names, numbers and future prospects are the basic tenets of any successful long-term investment in the sharemarket.
This argument relates to the idea of "diworsification", a term popularised by Peter Lynch the famous investor. He was referring to companies that made poor decisions just for sake of diversification.
Sure, if you want 30 children, go for it.
But, chances are, your intellectual capacity will be tested if you try to buy 30 shares. For time-strapped people who are working, have kids and love watching cat videos on YouTube but still want to invest, 30 stocks is too many in my opinion.
Another argument is why would you buy your 30th best idea when you can buy more of your best?
For example, if I think Commonwealth Bank of Australia (ASX: CBA) is the best share on the ASX right now (I don't, by the way) then why would I load up on Telstra Corporation Ltd (ASX: TLS) shares?
Referring to the chart above, there is one glaringly obvious question you are probably asking: 'Doesn't holding just 15 shares increase your risk?'
The answer isn't what you would expect: Maybe.
Evans and Archer (1968) believed 10 stocks was enough to remove most of this 'risk', while holding 20 stocks lowers portfolio 'risk' by 70%, according to Efficient Frontier.
But I have highlighted 'risk' for a reason. Ultimately, I believe it depends how you define risk. If you think risk is the ups and downs of share prices, you should consider holding 30 stocks or more.
However, if you believe (read "know") that stocks are just part ownership of a business, ask yourself: Would you think about the changes in daily or annual prices of that business as 'risk'? That's how academics define it.
For example, do you think a plumber who starts their own business would rather buy into 30 other plumbing businesses at the same time because it lowers risk?
The only difference between the plumber and an investor buying shares is that Mr Sharemarket gets in the way and sometimes sends share prices all over the place, which makes us nervous.
But if you focus on the business, like the plumber would, other investors will eventually catch up and price the shares accordingly.
A recent study conducted by leading investment research house, Zenith Investment Partners, found that 70% of investment grade managed funds with a concentrated approach to investing beat the market over the year to November 2016.
"Zenith believes the key attraction of concentrated funds is that they should in theory contain only a manager's best ideas. Typically, portfolio construction will be without regard for the benchmark and therefore these funds will not hold benchmark linked positions purely for risk management purposes."
AsteRISK*
My belief that less produces more comes with one big asterisk:
"Diversification is protection against ignorance. It makes little sense if you know what you are doing." — Warren Buffett
You can still make money having a diversified portfolio. So, if you don't have the time to understand the shares/businesses you own because you have 30 mouths to feed, then it would make sense to hold a diversified portfolio. The Vanguard MSCI Index International Shares ETF (ASX: VGS) holds 1,591 shares and has returned 8.23% over the past year.
