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Over-diversification can cost you money

Research has shown that the prices of individual stocks have become increasingly volatile since the early 1960s. This has led some to conclude that you need as many as 50 stocks to properly diversify your portfolio. We have some reservations about this advice.

Over_DiversificationIs your stock portfolio diversified enough? Probably not, according to Mr. Burton G. Malkiel, professor of economics at Princeton University. He says the increasing volatility of individual stocks in recent decades means you need far more than 20 stocks for adequate diversification. We have some reservations about Mr. Malkiel’s advice on this score. In fact, as we’ve often said, you should limit your stock holdings to about 20 well-diversified companies.

Mr. Malkiel measured the volatility of individual stocks in different ways and looked at the variance in daily, monthly and quarterly returns over a 35-year period following July, 1962. In all cases, he found that the volatility of individual stocks increased sharply.

Stocks have become more volatile

Mr. Malkiel points out, for example, that higher volatility frequently shows up in the largest percentage point gainers and losers published in The Wall Street Journal. He says: “It used to be that the movement up or down was in the neighborhood of 10 per cent, but it is now up or down 50 per cent.”

This may come as little surprise to you. After all, North American stock markets have become volatile in recent years. Stock market indexes often rise or fall several hundred points—often even in just one trading day.

This likely reflects the fact that large institutions account for more than 80 per cent of stock trading. Their huge buying and selling can greatly affect the share prices of companies. As a result, Mr. Malkiel concludes that investors like you now need a lot more than 20 stocks to diversify away company-specific risk—something academics like Mr. Malkiel refer to as idiosyncratic risk.

Mr. Malkiel says: “Now, given that individual stocks are much more volatile, 20- and even 50-stock portfolios still contain a significant amount of idiosyncratic risk. To eliminate idiosyncratic risk in today’s market, a portfolio must hold many more stocks than the 20 stocks that in the 1960s achieved sufficient diversification.”

One thing you should keep in mind, however, is that his research focuses on the US stock market. Stocks there typically soar and plunge much more than Canadian stocks. To the extent that the Canadian stock market is less ‘efficient’ (information takes more time to affect stocks and has less of an impact on prices), you actually may need fewer stocks than Mr. Malkiel thinks.

Over-diversification ensures mediocrity

Another thing to keep in mind is that the size of your portfolio involves trade-offs. On the one hand, raising the number of stocks can reduce the impact that a disappointing stock, such as General Electric, will have on your portfolio. But at the same time, of course, it guarantees that your most successful stocks will have less impact as well.

Another drawback with buying too many stocks is that it makes it difficult to keep track of your portfolio. Buying more stocks means more annual and quarterly reports to read, more earnings and dividends to check, more mergers and acquisitions to consider and so on.

Can you keep track of them all?

And look what happened to Mr. Peter Lynch, the highly-successful former manager of Fidelity’s Magellan Fund: he fell victim to over-diversification. Mr. Lynch has sheepishly admitted that he sometimes ended up buying stocks that he had already bought but had just forgotten about. His advice is: “Hold no more stocks than you can remained informed on.” We agree.

On balance, we recommend you continue to limit your stocks holdings to about 20 well-diversified companies. Only buy more stocks if you enjoy investing and have the time and discipline to properly manage a larger portfolio.

Just keep in mind: if Mr. Lynch can over-diversify despite his job, so can you.

This is an edited version of an article that was originally published for subscribers in the December 1, 2017, issue of The Investment Reporter [1]. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter [1].

The Investment Reporter [1], MPL Communications Inc.
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