How Much Diversification is Too Much?
Gerry Cameron - Feb 15, 2019
. . . there is another school of thought that truly believes diversification can have serious flaws.
I’m amazed when I watch money managers on investment shows taking calls from viewers. I’m amazed because these managers always have an answer when asked why this stock is going up, why that stock is going down, and why some obscure stock should be bought at this moment. And talk about stats. Most of these managers can spout off company statistics that can make a mathematician’s head spin (think Dustin Hoffman in Rain Man). It’s impressive. But truth be known, I’m more interested in looking at their portfolios to see what companies they are holding. And when I do, I sometimes find myself asking this question: “Why is this manager holding so many stocks in one portfolio?” True, these managers have teams of research people and traders to monitor the assets, and diversification is a well-known strategy to reduce risk when you invest in the markets. But is it possible to diversify to the detriment of the portfolio?
Conventional wisdom says to buy a large number of companies across different industries to create the proverbial “market portfolio”. Why? Well for starters, it’s been proven that no one, including the brightest investors, can be 100% certain that an investment will move up in value. Unforeseen events, known as Black Swans, can have a negative effect, even on the best and most-watched companies. For instance, unexpected weak company reports, management shakeups, product recalls, and accounting scandals (think WorldCom and Nortel) can cause any stock to fall in price. Then there’s the case of having one or two stocks tumble in a portfolio. If the portfolio is well diversified, as most advisors suggest, the drop in the price of the two underperforming stocks should not hurt the overall performance. As the saying goes, “Don’t put all your eggs in one basket”. And both are valid arguments.
But there is another school of thought that truly believes diversification can have serious flaws. First, this school feels that even the best-intentioned diversified portfolio is not going to save you in a bear market. When a bear market is taking place, the markets are in decline. Share prices continuously drop, causing a downward trend that investors believe will continue. This leads to more selling which, in turn, leads to lower prices. It can get ugly and painful, which we are seeing in today’s market with all the volatility, stocks declining as much as 20% from their highs. And yes, markets do recover; we have seen 32 bear markets from 1900 to 2015, but again, even the most diversified portfolios can get caught in the downward spiral.
Secondly, the more stocks you own, the more time is needed to effectively manage them. This means reading the quarterly earnings reports to see if sales are growing and earnings are higher than they were in the previous 12 months. It also means keeping informed of new products and services coming into the market and, more importantly, seeing that management decisions drive up sales and earnings in the future. This all takes time, but it’s essential to recognize potential pitfalls and hopefully avoid any future dangers. Holding a large number of stocks can make this task almost impossible.
And finally, a number of investors feel strongly that broad diversification can dilute your returns – water down any strong performers in your portfolio. For example, if you hold one or two stocks that are hitting home runs, let’s say returning 50% for the year, but their positions are equally weighted among 30 or more stocks with each stock given the same amount of savings invested, these two big winners will be lost in the rest of the holdings. This is critical. In this case, diversification which is put in place to protect your portfolio is actually harming it.
At the end of the day, this school believes it’s less risky and more rewarding to focus on a small number of stocks: Companies that have time and time again proven to be leaders that come from top industries. Companies that you have researched carefully and have shown to have large profit margins and strong management. Companies that help you maximize your gains.