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From the untrained beginner to the seasoned pro, virtually all investors must ask themselves a simple question: is my portfolio properly diversified? Given its importance, it is not surprising that diversification is one of the most widely discussed of all investing topics. In fact, a quick search of Google under the term "portfolio diversification" yields an astounding 7.3 million results. Yet, it also happens to be one of the most controversial. How many stocks should the average investor hold: 12? 25? 100? Ask this question to ten different experts, and odds are good you will receive ten widely varied responses. Some believe that the key to reducing risk is to invest in mutual funds that might spread their assets among several hundred securities. At the other end of the spectrum, there are others like Warren Buffett who insist that "wide diversification is only required when investors do not know what they're doing." (Incidentally, around three-fourths of the assets at Buffett's Berkshire Hathaway are tied up in just eight companies.) To a large extent, the answer depends upon an individual's unique goals and risk tolerance. Generally speaking, investors attempting to build their wealth might be better off with more concentrated portfolios, where a successful stock pick can make a meaningful difference. On the other hand, those more interested in capital preservation might need a larger portfolio, where one or two money-losing investments will have minimal impact. Either way, there is no definitive right or wrong number. While the debate rages on, we tend to give little credence to any of the arguments insisting that an investor needs to hold a designated number of stocks. Ultimately, the amount of stocks in the portfolio is not nearly as important as the composition of the portfolio. A Tale of Two Investors Building an efficient portfolio is much more of a qualitative challenge than a quantitative one. Some investors might be well-positioned with less than twenty stocks, while others could hold over a hundred and still be susceptible to extreme volatility. To maximize one's risk/reward profile, an investor needs exposure to a broad cross-section of different industries and asset classes. To illustrate the point, let's take a closer look at the portfolios of two hypothetical investors: Mr. Jones and Mr. Roberts. Back in the late 1990s, Mr. Jones was highly bullish on the technology sector, so he began scooping up a number of promising tech-related stocks, from well-known giants like Microsoft to tiny start-up companies and untested dot.coms. He knew that placing all of his bets in just a handful of stocks was a risky proposition, so he invested in dozens and dozens of companies to reduce volatility. By spreading his assets thin, Mr. Jones was convinced that his sprawling portfolio was sufficiently diversified to withstand a sharp downturn in the market. Unfortunately, when the tech bubble collapsed several years later, investors began dumping nearly all technology-related stocks indiscriminately -- there was simply nowhere to hide. Though Mr. Jones owned a large number of companies, they all seemed to trade in the same direction, and very few escaped the wrath of the bear market sell-off. Today, with the tech-heavy Nasdaq still trading at less than half its all-time peak, many of the stocks in Mr. Jones' portfolio are still under water -- despite having recovered sharply in recent years. During this same period, Mr. Roberts built a far more balanced portfolio -- buying each of the 30 components in the Dow Jones Industrial Average. This well-rounded group includes prominent companies spanning a wide variety of different industries, including financial institutions like J.P. Morgan Chase, media and entertainment firms like Walt Disney, beverage makers such as Coca-Cola, and retailers like Wal-Mart. Though he owned far fewer stocks, Mr. Roberts was actually more diversified and much less susceptible to the tumultuous bear market. By investing in different industry groups that weren't highly correlated to each other, some of his holdings zigged while others zagged. To be sure, some stocks lost money during that difficult stretch, but others held their ground -- or even showed a profit. As a result, Mr. Roberts would be sitting on a fairly sizeable gain today. Still, he could have done even better. Diversifying among different industries is a good idea, but it is only the first step on the path to diversification. The next is to ensure that your assets aren't tied up in just one corner of the market -- like domestic large-cap value. A carefully crafted portfolio will have a delicate blend of contrasts: growth and value, large and small, equity and fixed income, domestic and foreign, etc. Don't Chase Returns As history has proven over and over, the markets are extremely cyclical. One year, large-cap stocks might be all the rage. But the next year they could lose favor and small-caps might gain the upper hand. Unfortunately, trying to time the markets is almost never a good idea -- even for the most accomplished market strategists. The forces that dictate which asset class climbs to the top of the chart during any particular period are dynamic and influenced by anything from relative valuation to interest rates to global macroeconomics. Not surprisingly, it is exceedingly difficult to predict exactly where tomorrow's money will flow. And there is evidence to suggest that market timing is getting even harder. In a recent letter to shareholders, the top executives at Royce Funds (who have been highly regarded managers in the micro/small-cap arena for decades) had this to say on the subject: "We do not expect anything resembling the previous ten years in terms of the time span of asset class leadership…We continue to believe that the stock market will be characterized by frequent leadership rotation." To put this into perspective, let's see how three different hypothetical $10,000 investments would have performed from the beginning of 1985 to the end 2005 if investors had used the following strategies. • Investor A believes in momentum and invests entirely in the previous year's top performing asset class. • Investor B believes that sector rotation will eventually benefit whoever is at the bottom and invests exclusively in the prior year's worst performing asset class. • Investor C maintains a diversified portfolio, and invests in the varied stocks that comprise the Dow Jones Industrial Average
While we would like to see Investor C's portfolio comprised of stocks other than the large-cap blue chips in the DJIA, the chart shows that maintaining a well diversified portfolio can lead to significantly higher returns over time -- particularly on a risk-adjusted basis. Good investing!
Paul Tracy founded StreetAuthority and became Chief Investment Strategist in 2001. Prior to that he spent several years as Managing Editor at a multi-million dollar financial publishing firm with over 150,000 subscribers. In addition to his role as managing editor and lead financial writer, he was also responsible for equity research and managing a team of seasoned professional financial writers, researchers and market commentators. Paul's previous experience includes a position at Robert W. Baird & Co.'s full-service brokerage operations as well as economic research work on a Money and Banking project funded by the National Bureau of Economic Research. He has also spent time doing outside consulting and research for the University of Virginia, has appeared as a guest expert on several prominent financial radio shows, and has been a featured speaker at various investment conferences across the U.S. Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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