Balance your basket

Published in the Herald Sun, May 2014 by Karina Barrymore

Diversity in your portfolio can be a wealth creator, but there are limits, writes Karina Barrymore.

Need a good investment strategy or a better fund manager?

Then small and dedicated is the way to go, as big lumbering portfolios get the thumbs down in new research.

Despite being the number one rule of investing, diversification can increase risk and reduce profits, according to Ron Bird, a director of financial research house the Paul Woolley Centre.

Fewer, more carefully chosen shares are better than a broad portfolio, he says, as over diversification cannot only dilute the performance of the good shares and cost more to manage but can also add unwanted risk.

“The research shows it’s better to buy the best shares you can and put them together in a smaller portfolio,” says Prof Bird, an academic and researcher.

“It’s better to run a highly concentrated portfolio of shares that you really like.”

He acknowledges this can be difficult for retail investors “unless they have millions of dollars to invest”.

“But someone will come up with a product of the best managers, and the stocks they like the most, and put them together in a package for retail investors,” Prof Bird says.

“Alternatively, they can think like a fund manager. 

Typically a manager can only identify about 15 stocks worth investing in at any one time, so the best message for retail investors from this is to have a more concentrated portfolio.’’

AMP head of investments Shane Oliver also says over diversification can be a problem but the best strategy is somewhere in the middle. “Sure, you don’t want all your eggs in the one basket but diversify only to a point.

Diversification often gets carried to the extreme and people can end up with too many stocks,” Dr Oliver says.

“What you end up with then is a well-diversified portfolio of both winners and losers, so you might as well just invest in an index fund.

“You don’t want to throw the baby out with the bathwater and just have one or two stocks but you do need to strike a balance.

“Sometimes 10 or 15, maybe up to 25, stocks can provide plenty to work with then only focus on those where you have a high conviction — and if you look, that’s often how most fund managers start out."

Dale Gillham, an analyst at fund manager Wealth Within, has also written a book about the risks of diversifying.

Too many shares make a portfolio worse, not better, he says.

“To overdiversify is to worsify," Mr Gillham says.

“Once 12 shares are held in a portfolio the reduction in risk to that portfolio from diversification becomes minimal.

“Holding more shares from this point on is largely a waste of time as it starts to reduce the ability of the portfolio (to perform well).

He suggests investors only hold eight to 12 stocks “to have a properly diversified portfolio that will outperform the market".

“This also raises questions about the ability of fund managers to add value above what a normal investor could do for themselves," Mr Gillham says. 

“The financial services industry pushes diversification as a way to reduce risk, which in some degree is correct, but at what point does further diversification of a portfolio become largely a waste of time?”

The risk with a small portfolio, or choosing a managed fund with a highly concentrated portfolio, is that everything hinges on the share selection.

Stock picking becomes the priority, however having a stop-loss on every share is one of the simplest and most effective ways to protect against the downside risk, Mr Gillham says.

According to Prof Bird, an academic at the University of Technology Sydney, the skill of the fund manager is also crucial when choosing a small concentrated fund.

“If they are skilful at being a concentrated manager then the chances are higher of getting a good outcome. But if they are bad, then the chances are higher of getting a bad outcome,’’ he says.

“The danger is you are more at risk to the talents of the manager.

“The problem with the fund management industry is, as a consumer you can’t judge quality. 

“As a consumer you can identify the difference between a BMW and a Kia and then you can make your decision. 

As an investor you can’t judge who is a good manager and who is inferior.

“That’s also one of the reasons why we don’t have any price competition between fund managers in this country, because we can’t distinguish between managers.”

However, he says there are “behaviours” that are typical of good managers to help make a choice.

Those who think and act like they are better, often are, he says.

“Evidence strongly supports that managers who behave as though they are above-average achieve the best performance.

“A manager willing to take a bigger position on stocks, be overweight in an industry more than others, take bigger bets on investment style, be willing to go further from their rules — and not doggedly stick to their knitting through thick and thin — these behaviours indicate a better manager.”

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