What is a Well Diversified Portfolio?
By Dale Gillham | Last Updated 06 November 2018
The truth is that just about anyone can construct a well diversified portfolio and achieve good returns without too much knowledge or risk. The key to being successful is to practice good portfolio management. Therefore, what follows is a practical framework that will allow you to not only create a well diversified portfolio but ensure you only select stocks that have a higher degree of being consistently profitable. So let's get started.
Diversification or di-worsification?
We have all heard that we need to diversify in order to reduce risk, but how many of you actually understand diversification in its true sense. According to the financial services industry, you can achieve greater diversification by investing in managed funds than if you invested directly yourself. But in my experience, managed funds hold up to 100 different stocks in their portfolio, which not only increases transaction and other costs, but also the risk of the portfolio.
While it is true that diversification reduces risk, a portfolio of stocks that is over-diversified is exposed almost exclusively to market risk, which cannot be eliminated by diversification. Let me explain.
An investor who chooses to invest in a particular market is exposed to the risks inherent in that market, such as the economic influences of inflation and interest rates that affect the market as a whole. Therefore, the market risk remains regardless of the degree of diversification of the portfolio. However, an investor must also contend with specific risk, which refers to the risks inherent in a company or particular events in a sector that influence specific securities. The total risk, therefore, is the sum of the market risk and the specific risk of the individual positions.
The specific risk is very high if an investor concentrates in only one security, but the more a portfolio is diversified, the less the specified risk. When diversifying a portfolio it is important to know how much a specific stock contributes to reduce the general risk.
A stock from a different economic sector contributes more than a stock from the same sector because it is unlikely that all sectors will perform the same over time. For example, if one of the major banks is performing poorly, it is highly likely that all the banks will be performing poorly because they are subject to the same economic conditions. Obviously, the inverse of this argument also applies. This is why we are told that the greater the number of different stocks from various sectors held in a portfolio, the lower the specific risks incurred.
The managed funds, however, are bound by compliance regulations that stipulate how they should weight their portfolios. As a consequence, they are unable to invest in concentrated portfolios, which is why they continue to justify the argument of over-diversification. However, remember—a portfolio that is over diversified is exposed almost exclusively to general market risk, which cannot be eliminated by diversification and results in average returns at best.
What is a well-diversified portfolio?
So how many stocks do you need to hold to create a well diversified portfolio as an individual to achieve maximum diversification and to minimize or manage your investment risk?
One of my golden rules to investing in shares is to only hold between 5 and 12 stocks in your portfolio. As a trader, if you are looking to achieve higher returns, you invariably need to take on a higher level of volatility to outperform the market. Therefore, you need to hold a smaller number of stocks (between 5 and 8) to actively manage the specific risk. If you are an investor who does not have the time to manage the specific risk, then holding a portfolio of between 8 and 12 stocks will enable you to reduce volatility without dramatically reducing returns.
Increasing your holdings beyond 12 stocks exposes your portfolio to market risk, which as we have already indicated cannot be eliminated by diversification. This is supported by investors who have been questioning the conventional wisdom of over-diversification, preferring to invest in concentrated portfolios given the average returns achieved by many of the managed funds.
The reason for this is that you don't get twice the benefit from holding 20 stocks than you do from holding 10, and you certainly don't get 10 times the benefit from holding 100 rather than 10. Given this, it seems unrealistic to justify why anyone would put in the additional time, effort and analysis to find stocks when the diversification benefit is so small.
Obviously, if you want to improve the returns you get in your portfolio, it makes sense to simply get rid of the stocks that are going sideways or down. After all, we only want to hold stocks that are rising in price, don't we?
Over the many years I have been supporting traders and investors in the share market, I have seen portfolios constructed with up to 30 stocks or more. And in every case I found a third of the stocks rising, a third going sideways and a third going down with the portfolio achieving, at best, an average return. The bottom line is that if all the client had done was remove the shares that were falling in price, their returns would have been much better. Obviously, this is because the shares that are falling in value are eroding the gains of the shares rising in price.
Money management and risk
Regardless of whether you consider yourself a trader or investor, money management is critical to your success in achieving good returns when creating a diversified portfolio. In fact, the two elements of risk and money management work hand in hand.
We know if we put half of our money into one share and the remainder into another seven, then our specific risk will be very high. Therefore, to reduce our risk we need to ensure that the amount we invest in each share is no more than 20 per cent of your total capital.
If you are an investor holding between 8 and 12 stocks you would invest between 8 and 12 per cent of your total capital in each stock. For example, if you invest 8 per cent in each share you will have approximately 12 stocks in your portfolio, while if you invest 12 per cent in each share, this allows you to hold 8 stocks in your portfolio. As a trader, the amount you invest in each share may be greater; although you should never invest more than 20 per cent of your total capital in any one stock.
Selecting stocks in a well-diversified portfolio
Now that you have a basic framework for how to create a profitable portfolio, let's investigate how to select the stocks you should place in a well diversified portfolio that will give you a higher chance of being consistently profitable.
The list of stocks you select for your portfolio will depend on the time you have available, your resources and the goal of your portfolio. That said, the vast majority of you should not stray too far outside the top 150 stocks on an exchange by market capitalization for the following reasons:
- The top stocks are highly liquid - in other words, there is a lot of buying and selling taking place in these stocks every day, which means even in the event of a dramatic stock market crash, you will still be able to sell these companies quickly and easily;
- The top stocks are generally profitable businesses with some of the best managers, providing stability in the growth of the company and the stock price;
- The top stocks are purchased heavily by the institutions, therefore, they are less likely to be affected by mass panic buying and selling;
- Reliable information about these stocks is much easier to obtain;
- The chances of any one of these companies going broke is very small; and
- Over a ten-year period, the majority of these stocks will produce very good returns from both capital gains and income from dividends.
Unfortunately, many newcomers to the stock market mistakenly believe that investing in blue chip stocks is too expensive and that buying small cap-stocks or cheap stocks is the best method for achieving higher returns. But this belief not only costs you money, it hinders your ability to generate profits because you are investing your faith in speculative stocks. In other words, you are speculating that a cheap stock will outperform a solid blue chip stock, whereas in reality the opposite is true.
The fact is you want to buy quality stocks, not quantity because this is were you will get the greatest gains at the lowest risk. Furthermore, it has been proven that concentrated portfolios perform far better and provide lower levels of risk. Therefore, when constructing your portfolio you should look to hold between 5 and 12 stocks and only invest in the top stocks by market capitalization. If you take this low risk methodical approach to investing over the long term then, 9 times out of 10 you will achieve far higher returns than if you try and beat the market averages by picking the next boom stock.
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