Prudent Portfolio Diversification

Posted on 28/01/2011

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Economists and businessmen are often known to say “there is no such thing as a free lunch”; however, there is one exception to this rule: portfolio diversification.  By spreading his wealth across a number of assets an investor is able to reduce portfolio risk at no cost and with no loss of expected portfolio return.  Consequently, diversifying a portfolio is now treated by most investors as a conventional wisdom or golden rule.

Although with respect to the stock market such advice is well-known (and followed), with simplistic phrases such as “don’t put all your eggs in one basket” serving as a useful reminder, once people think about buying a home such maxims are quickly forgotten.  People who would worry about making direct investments in stocks, even “blue-chip” multinationals with billions of dollars in assets and multiple revenue streams, are on the other hand happy to invest 100% of their net worth as a mortgage deposit (often levered 10-20x)  in order to buy their first home.  Such reasoning makes no sense at all.  Clearly this portfolio has no liquidity and contains only a single asset, an asset which is highly dependent on the success of the local economy and can have its value significantly impacted by nearby developments (would you like a prison, sewerage works, heroin addict needle exchange, etc near your property?), weather/geological events (flooding, subsidence) or simply by anti-social neighbours.  I would rather take all my assets, leverage them up and invest in a the equity of a successful multinational such as Vodafone than in a single residential property.

The reason I take this view is that large multinational companies are already incredibly diversified assets.  Using the example of Vodafone, it has 343m mobile phone customers and operates in 40 different countries, meaning that changing levels of GDP, competition, taxes or regulations in any one geography only has a relatively small impact on the business as a whole.  I could suggest a large number of other companies which offer similar (or greater) levels of diversification.  The level of diversification within an individual company can be seen as a positive function of: the number of countries in which the business operates; number of different products that the company sells; and the number of different individual customers that the company sells to.  Separate, though related, is the cyclicality of the company’s products, with non-cyclical products and services offering investment safety in a different manner.

When individuals make investments in the stock or bond markets, they most often do so through investment products such as their pensions (which may be defined benefit or defined contribution) or collective investment schemes such as mutual funds, unit trusts, ETFs or investment trusts.  Such instruments typically provide exposure to many tens of different companies – a reasonable number of which may be diversified in a similar manner to Vodafone – and in the case of ETFs to the whole stock market (500 companies, obviously, for an S&P500 ETF).  Having just thought about how Vodafone and other large companies are themselves diversified, this suddenly sounds like too much diversification, particularly given that more diversified portfolios are likely to have higher trading costs due to their smaller trade sizes (trading commissions are lower – in percentage terms – for larger trades) and potentially poorer – or more average – investment results (a manager of a large portfolio must divide his time and attention between a much larger number of companies, meaning he cannot understand them all in the same detail as the manager of a smaller portfolio, while the law of large numbers means a diversified portfolio must perform close to the market indices, less fees and expenses).   So if investing all your wealth in a single asset (eg a residential property) is too concentrated and investing in a fund may provide too much diversification, then what level of diversification is optimal?

Risk Reduction and Portfolio Diversification: An Analytical Solution” by Edwin Elton and Martin Gruber (Journal of Business, 1977) found that the benefits of diversification are negligible once a  portfolio increases in size beyond 20 different investments, as can be seen from the chart below, which plots portfolio standard deviation against the number of holdings.

Consequently, by increasing a portfolio to around 20 stocks an investor is able to capture the “free lunch” benefits of diversification, but beyond this there are little further gains to be had, as systematic (market) risks cannot be diversified away.  This research was recently repeated for the Indian stock market by Lokanandha Reddy Irala and Prakash Patil in “Portfolio Size and Diversification” (SCMS Journal of Indian Management, 2007) who found that 10-15 stocks are sufficient to achieve the majority of the benefits of diversification.

Even with very little thought it is possible to construct a highly diversified with only a handful of stocks.  For example, I believe a portfolio containing the following ten stocks would be able to achieve almost all the benefits of diversification: HSBC; Vodafone; Royal Dutch/Shell; BHP Biliton; General Electric; Tesco; WPP; Proctor & Gamble; Samsung Electronics; and Toyota.  Such a portfolio contains companies that operate in most major sectors and across all continents, providing exposure to most key economic trends.

In conclusion, I would consider a prudently diversified portfolio to contain between 10 and 20 different stocks, with a greater number needed if the companies: are small; have few products; operate in few countries; or operate in cyclical industries; and a smaller number of stocks  if the opposite is true.

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