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20 Stocks is NOT Enough.


From time to time, Individual investors see a claim that ‘20 stocks is enough’ for diversification.

This is baloney.

For most Individual investors, this theory doesn’t work in practice,

Those that claim 20 stocks is enough quote a 1968 paper by Evans and Archer that concluded that ‘a portfolio of randomly chosen stocks would have similar risks … to the market as a whole’. Others quote Warren Buffet who said “I think diversification is a terrible mistake” and “… you probably shouldn’t own more than six ….” Then various other Academic studies get rolled out to support the concentrated portfolio idea.

But the average Individual investor isn’t Warren Buffet. (And neither is the average portfolio manager).

More recent studies, show that while markets overall may be no more volatile than in the past, the average individual stock has become significantly more volatile (twice as high or more). A 20-stock portfolio today will not provide adequate diversification. For most investors, it will be too volatile. Any individual security could be either wildly successful or an abysmal failure (compared to a diversified portfolio).

(Despite what one might hear on the cocktail party circuit, there are very few ‘volatility-junky’ investors in practice. The average Joe or Jane investor is volatility-adverse. Every investor likes to win but, given a choice, would prefer to simply not lose).

What to do?

Logic.

Most agree that investment portfolios should be diversified. ‘Don’t put all your eggs in one basket’ makes intuitive sense. Traditional portfolio management makes the same assertion. The basic notion of diversification involves spreading out portfolio dollars in order to avoid excessive exposure to any single source of risk (and return). Indeed, diversification is a cornerstone or modern portfolio theory.

Learn by example.

An equal-weighted, 20-stock portfolio would have 20, 5% allocations. This is absurd. If any single stock approached 5% in an Institutional portfolio, heads would roll. (In fact, most Institutions have governance and policies in place so that red lights would go flashing long before any single position got to 5%). Why should an Individual’s portfolio look vastly different than an Institutional portfolio?

Look at the alternatives.

Most Individual investors have a ‘safety first’ criterion. For them, a handful of simple Exchange Traded Fund’s can buy immediate, inexpensive, diversification and exposure. Example:

Asset class Allocation Exposure to# Securities MER
Canada Bonds XSB 10% 185 0.25%
US Bonds BND 10% 3362 0.14%
Canada Real Estate XRE 10% 10 0.55%
US Real Estate VNQ 10% 98 0.15%
Canada Stocks XIU 20% 60 0.17%
US Stocks VV 20% 758 0.13%
International Stocks VEA 10% 935 0.16%
Emerging Market Stocks VWO 10% 816 0.27%
Totals: 100% 6224 0.21%

Exposure to (arguably) eight asset classes, 6,224 securities at a cost of 0.21% (using ETF’s) removing individual security risk is the opposite of ’20 stocks are enough’. This is the ‘anti-broker’ approach.

An Individual investor might take both approaches to establish a ‘Core and Satellite’, balanced portfolio (where most of the portfolio is in broadly and globally diversified ‘core’ ETF’s which are complimented by individual stocks (the satellites).

But rather than investigate individual stocks, Individual investors might be better off investigating individual Investment Managers (their philosophy, process …) and ‘hire’ them to do the individual security selection. Individual investors simply don’t have the skills, resources, access, time or inclination to successfully stock (or bond) pick.

There is nothing specifically wrong with a portfolio concentrated in 20 stocks. It’s simply not suitable for Individual investors.

In early 2006, I met a 70-year-old gentleman whom had by then accumulated nearly $1 million in four income trusts. He thought he was diversified. It’s tough to argue with success but sometimes what got you here won’t get you there.

Next time?

Buy CIBC.

Doug Cronk CFA is Manager, Investments for a Canadian Pension fund

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5 Comments Post a comment
  1. Isn’t the model portfolio above too light on fixed income, entirely missing real return bonds and infrastructure and perhaps commodities to be like the best pension funds such as CPPIB, OMERS, OTPP?

    Like

    May 10, 2011
    • Hi, Jean.
      Maybe a bit light on bonds … but i’m ok with the aggressiveness of my portfolio and what you see is the strategic mix … i am currently way overweight bonds. The market for real return bonds in Canada is so small that it’s difficult for the individual to participate. (There are ETFs. They are expensive and have limited volume). Infrastructure i lump in with Real assets. There are a couple of ETFs … see Claymore Investments … expensive, short track record and limited volumes. And commodites, well, any TSX ETF IS commodities … by definition. But if i had more money, sure I’d buy more ‘satellite’ ETFs like commodites (look at Coxe commodity fund) and infrastructure.
      Thanks.

      Like

      May 10, 2011

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