When Harry Markowitz, the pioneer of modern portfolio theory, stated that “diversification is the only free lunch in investing”, he did not intend to characterise the market as a buffet. Indeed, it might be tempting to hold a little bit of everything; global markets have never been more accessible, and the plethora of alternative investment vehicles expand every single day. Nevertheless, investors must avoid filling their plates too high and taking on insignificant and unproductive positions- why is this the case?
Taking a page from portfolio theory- risk manifests itself simultaneously in 2 key ways:
- Systematic Risk: These are risks associated with the wider economy that affect all securities (to varying degrees). Examples include interest rate changes, global pandemic, or hostile trade policies
- Idiosyncratic Risk: Also known as unique risk, specific risk or residual risk, idiosyncratic risk pertains to risk specific to a firm, asset, or security. In the context of stocks, examples of idiosyncratic risks may be capital structure, weak product, oversaturated market, or poor management.
Unfortunately, without the ability to significantly influence macro events, individual investors may be unable to eliminate systematic risk from their portfolio. Idiosyncratic risk on the other hand can be reduced by a variety of methods- the most straightforward of which, is to simply increase the number of holdings in one’s portfolio – “diversification”.
Safety in numbers
By doing so, we reduce the chance that any one bad outcome will render significant harm to the overall portfolio. In a simple exercise, Statman (1987) shows that a portfolio of even just 10 stocks- especially those across different sectors and industries- is much less risky than a portfolio of only two stocks. One can only imagine the upside of scaling this exercise.
However, the danger of this advice is that investors blindly take this and overload their portfolio with excessive positions in the pursuit of minimalizing risk. What the investor fails to see is that this results in unproductive positions that become expensive to manage and yield attractive returns.
We end up with risk-adjusted returns as such:
We can observe that at some level of diversification, our risk-adjusted returns (Sharpe ratio) plateaus or even declines. Which begs the question, what is the ideal number of stocks to hold in our portfolio?
What is the ideal number of holdings?
Is it 5 or 10? 15? Could it be 50 or even 100? How about 200?
Unfortunately, upon searching the annals of academic research or listening to the wisdom of some of the best on Wall Street, there is unsurprisingly, no singular consensus figure that optimises our returns. Looking at the best, Benjamin Graham-a famous doubter of broad mindless diversification- believed in rational metrics, and argued that a portfolio of 15-30 stocks was adequate so long as they meet certain strict criteria. Ray Dalio with this conservative opinion, arguing in his book Principles, that 15-25 uncorrelated investments are enough.
We must be careful to note that academic research could be more useful for constructing strictly quantitatively portfolios as opposed to forming reasonably high-quality stock portfolios for disciplined investors. Conversely, advice from individuals entail biases and different risk tolerances that may not apply to you.
Nevertheless, what most tend to agree on is the fact that a portfolio should hold no more than 50 stocks and that the Goldilocks zone lies between 25-35 stocks.
With 25-35 stocks, investors can reap the benefits of lower risks whilst also yielding attractive returns. It means that portfolios are not littered with holdings of insignificant value; holdings below 2% are generally unproductive and their protection against downside movements is negligible. When we factor in transaction and management costs, investors are better off increasing their allocation to another stock.
Researching individual stocks is a taxing process; having to filter through company reports, announcements, earnings calls, news etc is a time and resource-consuming process that increases exponentially as we increase our portfolio holdings. With diminishing returns to diversification, the trade-off between marginal gains and the cost of research is often, simply not worth it if we hold insignificant positions.
Although inconclusive in a specific amount, investors should walk away knowing that having a portfolio of many stocks- weighted under 2%- are generally unproductive and counter the upsides of diversification. Instead, investors may be better off targeting their diversification across different industries, sectors or even asset class. Nowadays, ETFs are a cost-effective method of adding reasonable diversification to one’s portfolio. In short, blindly diversifying in insignificant positions is not the most effective method of hedging risk.
And even if Markowitz did mean to characterise the market as a buffet, it would be irrational to want insignificant portions of everything as opposed to having a sizeable portion of a few attractive items.