Franklin Otis Booth Jr., one if the wealthiest men in America said “Diversification is dilutive of superior investment results” was the best investment advice he every heard.My Reply;
if i were smarter i would agree with himI have to say I am not sure why my co-worker sent me the email but it isolates two schools of thought about diversification. Some would tell you are diversified with only ten stocks while some portfolio managers own a 100 names for clients. I don't think there is a right or wrong to this just a matter of individual preference and any method chosen will have advantages and drawbacks.
Too few stocks and one blow up hurts the portfolio by a noticeable amount, too many stocks and you run the risk of a very expensive index fund.
I have written many times about 40-45 holdings being about right for the way I manage accounts. The thinking is simple as most of the names account for 2% or 3% of the portfolio. If a stock doubles in a year, with forty names there is a good chance that one or two stocks will go up that much, it could add as much as three percentage points to the entire portfolio. Combine that with an above market dividend yield, like in the mid two's, or higher, and you are adding 500 basis points to the portfolio before you even get started, which could be a bug chunk of what the portfolio needs to do that year depending on how the overall market does.
By the same token a 3% holding that cuts in half on you will simply cause a little lag as a worst case scenario.
Twenty holdings seems to be a popular number but for me that numbers places a lot more emphasis on having to be more narrowly correct. I find with 40 names there is less riding on my being right about which stocks will do well in a given time period.
Obviously a lot people want to try to be specifically correct about what 25 stocks will do the best this quarter. If you are active enough with your investing that you read stock market blogs you are probably well on the way to having this figured out for yourself but this can be evolving thing for most do-it-yourselfers.
If you are in the 20-25 camp and the late February dip caused you too much anguish you might want to revisit your method.
10 comments:
"Put all your eggs in one basket, and watch that basket."
roger, i have been looking at the telecom etfs for a possible entry. iyz, domestic tele, has gotten better liquidity but ixp, to me has better technicals..at least a few days ago. I wonder if the gap up this morning, looks like on 1000 shares which is what fidelity chart 1 minute frequency suggests, is due to someone buying at mkt on the open. The danger of these low liquidity etfs? Or is this a misprint. Curious if you find out reason for gap up.
mattyp, that quote is 100% appropriate for this discussion.
742 anon,
DGG (which a couple of clients own)opened higher in a similar manner, not exactly the same but similar.
You ask about low liquidity. This is obviously more important if you are going to trade or buy a large quantity for yourself.
Depending on the quote you probably need a limit order but very often the specialist will want to give a friendly fill. A reputation of being difficult to trade will hurt everyone involved.
If your order is obviously a retail sized order you should have no problem getting fills. If you are a 100-300 share buyer I would be shocked if the fill was something other than one price right away but you never know for sure.
I for one do not worry about liquidity issues but I am not trading them, I am holding on, hopefully long term.
Roger,
I have about 15 stocks, plus 5 mutual funds; which seems to me more than enough diversification and trying to follow what is happening with my portfolio. The portfolio was down about 10% and has recovered more than half of the "loss". I put the quotation marks around loss, because the majority of my stocks have been with me ten years and more. At least for me holding long term is successful.
Bernie
clearly 15 stocks and five funds could be good diversification, depending on the stocks and funds of course.
I have touched on this idea before. A given mix either behaves the way the investor wants or not. If yours does, great, if not...
I remember seeing a chart in Malkiel's Random Walk book that had standard deviation on the Y axis and # of stocks in a portfolio on the X axis. It illustrated the idea that you need approximately 50 stocks to get to a standard deviation close to the market as a whole. I don't know what methodology was used to select the hypothetical 50, but I assume it was a random pull.
James O'Shaughnessy suggested in his book What Works on Wall Street that most individials couldn't tolerate the volatility of porfolios (using his screens) with fewer than 50 stocks. The book is full of backtested portfolio stats on many mechanically screening strategies - most with 25, 50, and 100 stock versions so you can compare their standard deviations and sharpe ratios.
Obviously a portfolio could have far fewer than 50 if the manager used non-correlation criteria as part of their selection method. A services like Porfolio Science can help with this, right?
tomk portfolioscience probably would help but for my own take 25 names would rely too heavily on past correlation (or lack thereof) data would stand up going forward. To my way of thinking this creates greater chance for lagging short periods like we appear to be emerging from.
which raises another question. Isn't it more important to look at sector/industry correlations instead of individial stocks?
as a top down guy you know I am going to agree with that
From one individual with an over 7 yr hx of using software to determine number of asset classes to be invested in, and from another who professionally manages accounts with even longer history of investing top down .. as counter intuitive as it is, one asset class is the best number. Hard data can show outperformance and equal or better risk metrics. But to borrow a metaphor, it can be like watching sausage being made.
If tomk cranked up his exposure, his focused bets must be doing quite well. Personally, 37 percent exposed...my timid strategy but narrow asset class approach working so far...up 2.7 for the year. A sustained rally, though, will leave me in the dust.
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