INTRODUCTION
Famed economist Harry Markowitz once said that “Diversification is the only free lunch in investing.” Diversification is an essential tool in portfolio management and although it may be a simple concept, significant complexity arises in balancing the risk reduction benefit generated by adding holdings to a portfolio and maintaining conviction in portfolio weightings to generate an active return. The optimal number of holdings to balance these two objectives is unknown, however, our investment philosophy at Bellamont Wealth Management is centered around less is often more and concentration in the pursuit of an active return is better than a bloated number of holdings providing a false sense of diversification. The following article highlights our philosophy behind diversification and the optimal number of holdings within a portfolio.
SYSTEMATIC VS UNSYSTEMATIC RISK
From early on, most investors have heard the adage, “Never put your eggs in one basket” which has become synonymous with the term diversification. We’re taught that diversification is the key to minimising risk because owing non-correlating assets is less risky than owning one or a few. Practically, diversification is the recognition that you can’t know which investments will outperform others at any given time. So, by combining multiple assets, you should be able to capture returns whenever and wherever they occur while smoothing portfolio volatility.
A portfolio’s total risk can be separated into systematic and unsystematic and is measured by standard deviation which outlines the variability of the returns of a portfolio. Both systematic and unsystematic risk impact investments in various ways and require different mitigation strategies.
Systematic risk, also known as market risk, cannot be reduced by diversification within the equity market. Sources of systematic risk include, inflation, interest rates, war, recessions and market crashes. The unpredictability of these factors mean that systematic risk always exists and companies get caught up in the contagion of market forces, just as the rising tide lifts all boats.
Unsystematic risk, also known as company-specific risk, represents risks of a specific corporation, such as competition, sales, regulation, product recalls, labour disputes and brand recognition. This type of risk is unique to an asset and therefore can be eliminated through diversification.
The key take away from the above differentiation between the two types of risk is that systematic risk cannot be diversified away as is it something that all companies operating in the market face whilst unsystematic risk, because it is unique to each company can be reduced through diversification.
The nature of systematic risk highlights the importance of owning the high quality companies because their healthy balance sheets and strong cashflow conversion enable them to provide strong relative performance in difficult market environments. While quality companies are not immune to market distress, we at Bellamont believe that investing in companies that have understandable business models, transparent financial statements, sensible capital allocation as well as having a history of developing both growth and real economic value are less susceptible to difficult market environments and provide an added layer of diversification against market risk.
DECAYING BENEFITS OF DIVERSIFICATION
“Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.” – Phil Fisher, 1958.
Numerous studies have been conducted to determine how the addition of holdings to a portfolio produces diminishing returns, both in terms of additional risk reduction and reduced expected returns. Benjamin Graham, “the father of value investing,” estimated that the optimal number of holdings within a portfolio that balanced risk reduction and expected returns was between 10 and 30. In a study by Frank Reilly and Keith Brown, they found that portfolios containing 12 to 18 stocks provide about 90% of the maximum benefit of diversification. In addition, optimal number of holdings is also dependent upon investment objectives, risk tolerance, investment preferences, investment preferences, time horizon as well as market conditions. Therefore, the optimal number of holdings will be unique to each portfolio.
BENEFITS OF DIVERSIFICATION DECAY QUICKLY
Diversification – Total Portfolio Risk as a Function of Number of Stocks Held (%)
Source: Dresdner Kleinwort Macro Research.
However, what is clear is the decaying benefits of diversification, as the graph above illustrates is that as additional holdings are added to the portfolio the standard deviation of returns reduce. Once the number of holdings reaches 20 to 25 the unsystematic risk is largely diversified away with only systematic risk remaining. Increasing the number of holdings above 25 provides limited diversification benefit but would impose costs in the form of monitoring and analysing additional holdings as well as compromise the quality of the portfolio.
In addition, finding, researching, selecting and tracking 20 to 30 quality companies is far more manageable than 80 to 100. It’s much easier to gain an advantage when you own and include companies that you know well. If you start adding companies just for the sake of more diversification, you are likely sacrificing quality, which can expose your portfolio to greater risk. The objective should be to achieve enough diversification and still be able to understand why you’re invested in each of the companies in your portfolio.
Perhaps the biggest trade-off for equity portfolio managers is between specialisation and risk reduction. The smaller the number of companies researched and included in portfolios, the more likely that portfolio manager will be able to generate alpha through a better understanding and focus on high conviction positions. However, on the opposite end of the spectrum, the lower the number of companies included in a portfolio the higher the unsystematic risk which increases the odds of outsized losses.
CONCLUSION
Diversification and the optimal number of holdings within an equity portfolio is a complicated issue and unfortunately there is no unique answer. However, what is clear is that a limited number of holdings is required to eliminate a large proportion of company specific risk and addition of holdings beyond this point will likely impose costs that outweigh the additional risk reduction benefit. A concentrated portfolio of approximately 25 holdings will likely balance risk reduction through diversification as well as maintain significant enough concentration in holdings to generate an active return. Therefore, we believe at Bellamont Wealth Management that putting your eggs in a basket as counterintuitive as it may seem is a key element to long-term investment success.
