How Diversified Should You Be?

July 6, 2016

How Diversified Should You Be?

  • Extreme diversification is good but only provides ordinary results results.
  • Concentrated portfolios proved better in some cases as they allow investors to select the best companies.

Introduction

A few days ago we discussed passive and active strategies given that there is a looming risk of a recession and that the markets are unable to break new highs which makes just holding stocks for the sake of holding stocks very risky. In this article we are going to discuss how diversified a portfolio should be as it is easier to pursue an active strategy with a concentrated portfolio of stocks.

Diversification

Diversification is the process of allocating capital in a way that reduces the exposure to the individual risks of any particular asset. But the question is how much diversification is too much or too little?

On one side we have the “efficient market hypothesis” believers that promote a “market portfolio.” A “market portfolio” is a portfolio that holds every traded asset in the market in proportion to its market value. On the other side we have investors who meticulously search for one, two or three good companies and put “all their eggs in one basket.”

The debate is an ongoing one where Mark Cuban once claimed that diversification is for idiots while John Bogle, the father of the index fund business, adverts massive diversification through his Vanguard funds. As said on the Vanguard web page: “Each all-in-one fund invests in thousands of individual stocks and bonds to help reduce the risk to your investments.”

Let us see how this extreme diversification performed in the last decade.

Name Ticker Asset Class Expense Ratio Price As of 7/1/16
($ Change, % Change)
SEC Yield YTD As of 7/1/16 Average Annual Returns: 1 Year Average Annual Returns: 5 Years Average Annual Returns: 10 Years Since Inception
Federal Money Market VMFXX Money Market 0.11% $1.00 ($0.00, 0.00%) 0.32% 0.15% 0.18% 0.05% 1.07% 4.41%
(07/13/1981)
GNMA VFIIX Bond – Interterm Government 0.21% $10.87 ($0.02, 0.18%) 1.98% 3.24% 4.17% 3.04% 5.01% 7.53%
(06/27/1980)
Intermediate-Term Corporate Bond Index Admiral Shares VICSX Bond – Interterm Investment 0.10% $23.97 ($0.05, 0.21%) 2.93% 7.77% 7.75% 5.82% N/A 6.43%
(03/02/2010)
Target Retirement 2035 VTTHX Balanced 0.15% $17.38 ($0.05, 0.29%) 2.13% 3.21% -0.67% 7.44% 5.74% 6.76%
(10/27/2003)
500 Index Admiral Shares VFIAX Stock – Large Cap Blend 0.05% $194.08 ($0.42, 0.22%) 2.11% 4.04% 3.95% 12.06% 7.42% 4.88%
(11/13/2000)
Developed Markets Index Admiral Shares VTMGX International 0.09% $11.38 ($0.04, 0.35%) -1.96% -8.55% 2.05% 1.92% 3.24%
(08/17/1999)
Emerging Markets Government Bond Index Admiral Shares VGAVX International 0.33% $20.01 ($0.11, 0.55%) 4.47% 10.45% 8.18% 4.08%
(05/31/2013)

Figure 1: Performance of Vanguard funds. Source: Vanguard.

All in all, the results are very positive over the long term. The Federal Money Market fund averaged 4.41% since 1981 but only 1.07% in the last 10 years. Bond funds had average returns of 7% since 1980 and 5% in the last 10 years. As for stocks, the 500 Index Admiral Fund managed to return 4.88% per year even if it was incepted in the midst of the dotcom bubble in 2000.

It can be concluded that there is nothing wrong with extreme diversification. Over the long term it will earn single digits returns, similar to the earnings of the underlying assets. With the current S&P 500 PE ratio at 24, diversified investors can expect returns of around 4% from stocks and 2% to 3% from bonds in the long term. Such returns will for sure beat inflation and keep capital well preserved.

Portfolio Concentration

Diversification opponents state that an investor is limited to mediocre returns if he buys the market, and that much better returns can be expected if the best assets available are selected and nothing is bought just for the sake of buying because it makes up part of the market.

Two great promoters of carefully choosing where to put your eggs are Berkshire Hathaway’s managers, Warren Buffett and Charlie Munger. They state that excessive diversification is madness and because it includes investments in mediocre businesses it only guarantees ordinary results. A look at Berkshire Hathaway’s performance since 2000 will prove that concentration outperforms diversification.

figure 2 berkshire hathaway
Figure 2: Berkshire Hathaway since 2000. Source: Yahoo Finance.

Berkshire Hathaway went from $51,200 in 2000 to the current $216,298. That gives a compounded annual return of 9.4% which beats the returns of all the Vanguard funds. The main ideology behind Buffett and Munger is don’t just buy something because everyone else is. This slight difference is the reason for the few extra percentage return points that create a huge difference in the long term. And still now, Berkshire has a PE ratio of 14.5 which will create better returns in the long term than the general market.

As Berkshire holds companies like Geico, Fruit of the Loom, Dairy Queen, Nebraska Furniture Mart, Benjamin Moore, See’s Candies, Burlington Northern and has investment positions in Wells Fargo, Coca-Cola, American Express, IBM and Heinz, it provides good diversification but not too much.

Buffett’s strategy is in line with the academic market portfolio theory that 20 stocks from various sectors is enough to eliminate stock specific risk from your portfolio and leave you with only market risk. As 20 stocks is not many, and many fewer than the thousands of stocks in the Vanguard funds, you might as well chose the best ones which will bring you additional returns with the same amount of risk.

figure 3 stock market risks
Figure 3: Number of stocks needed to eliminate stock specific risks. Source: Investopedia.

Of course, this does not mean that you can buy 20 different airlines and sleep well, the stocks should be from various sectors and have uncorrelated returns.

No Diversification At All

Some advocate a strategy where you put all your eggs in one basket, but a big survival bias holds this theory afloat. We constantly hear about the various Gates, Zuckerbergs or Ortegas that made huge fortunes by betting on one horse. But that was mostly their horse and we do not hear about the millions that lost it all by betting on themselves in the same way.

In Bloomberg’s billionaire top ten list there are two who arrived there by diversifying, Buffett and Slim.

figure 4 bloo
Figure 4: Bloomberg Billionaires list. Source: Bloomberg.

Conclusion

Let us start with saying that every strategy should outperform holding your capital under the mattress in the long term. Extreme diversification will achieve stable but ordinary results while less diversification and choosing the best companies at the best prices will help your portfolio outperform. On top of that you can be more active with a 20 stock portfolio and buy the cheaper stocks and sell the overvalued ones.