# How many shares do I need to hold to be adequately diversified?



## Jim2007 (5 Jun 2012)

Marc said:


> I recently invested in a fund which holds a globally diversified portfolio of 11,000 individual companies and has 15% exposure to emerging markets and 85% to developed markets including Ireland.





Marc said:


> All i know is that I have far more companies than most people so I am more diversified.



There is such a thing as over diversification... and with 11,000 companies I'd say that you've have hit it!!!


----------



## Marc (5 Jun 2012)

Jim

The late Merton Miller used to say that diversification is your buddy. Harry Markowitz says its the only free lunch in investing. 

They were both awarded the Nobel prize so I'll stick with the advice of my learned friends if that's ok.


----------



## Brendan Burgess (5 Jun 2012)

Marc said:


> The late Merton Miller used to say that diversification is your buddy.



Agreed, but you can have way too many friends. 11,000 is crazy diversification.



> Harry Markowitz says its the only free lunch in investing.


But you can eat too much.


----------



## Marc (6 Jun 2012)

How many stocks does it takes to have a well-diversified equity portfolio?

Adding more stocks to a portfolio causes the portfolio's volatility to decline ever closer to that of the market.

By continuing to add stocks at random, we can get the portfolio volatility as close as we want to that of the market and Investors often conclude that, at some point, the portfolio's volatility is "close enough" to that of the market, and the portfolio is therefore well diversified. All that remains is for each investor to decide what "close enough" looks like.

Today, investors can easily own a portfolio that is very close to a well-diversified, well-constructed market index. In other words, a very close approximation of a true "market" portfolio is available to most investors. In fact, it is probably cheaper for many investors to own a broadly diversified market portfolio than a highly concentrated, poorly diversified portfolio. If the diversification benefits of a market-like portfolio are readily available at a reasonable cost, why should anyone own fewer stocks?

Many investors would respond to this question by saying that there are only so many undervalued stocks, and those are the only ones that they want in their portfolios. This leads to concentrated portfolios, but they are willing to incur the resulting higher risk because they see the possibility of higher returns through security selection. The assumption underlying this response is that the investor has the ability to generate enough additional return to more than compensate for the lost diversification benefits.

How good at security selection would an investor have to be in order to accomplish this? 

In studies, 10-stock portfolio would require an expected monthly return 28 basis points higher than the market index, and a 50-stock portfolio would need an additional 10 basis points per month. These monthly numbers correspond to annual above-market performance of about 3.4%pa and 1.2%pa, respectively. Since the typical professionally managed equity portfolio lags the market after expenses, these seem to be high hurdles that would be very difficult for most investors to clear. As we add more stocks the hurdle becomes lower. However, since the majority of professionally managed portfolios have trouble clearing an excess return hurdle of zero, achieving even a small positive excess return should not be seen as a trivial task.

These estimated excess returns are probably understated, for two reasons. First, the portfolios of many investors are concentrated in just a few sectors, in addition to containing relatively few stocks. By concentrating in certain sectors, portfolios lose additional diversification benefits. The other reason is related to turnover. The search for undervalued securities tends to increase portfolio turnover, since it is necessary to sell stocks that are no longer seen to be undervalued, replacing them with a new set that the investor believes to currently be undervalued. Since turnover is costly, additional returns must be generated to cover the costs.

Of course it's not necessary to be a good stock picker in order to generate a higher Sharpe ratio than the market. Studies of historical returns tell us that portfolios of value stocks have accomplished this feat on average. While this is true, it is not necessary to give up diversification benefits in order to achieve a value bias. Asset class tilts do not require investors to hold concentrated portfolios.

What about the well documented benefits of international diversification?

For the January 1970-May 2008 sample period, the monthly standard deviations of a Value-Weighted Index of US stocks and the MSCI EAFE Index were 4.49% and 4.71%, respectively. However, the monthly standard deviation of a 50/50 combination of the two was 4.07%. International diversification has the potential to substantially reduce portfolio volatility. Therefore, a well-diversified portfolio should contain stocks from multiple countries. To maximize the potential diversification benefit, holdings should be diversified across continents and industries, and they should include both developed and emerging markets.

There are currently tens of thousands of publicly traded stocks around the world 11,000 represents a good slice of global capitalism but even this many does not really represent the whole "market"

But of course true diversification really means investing in different asset classes.

The post-mortem on the global financial crisis is raising the question in some minds about whether it is time to read the last rites for diversification — the principle that you reduce your investment risk by spreading it around.

Among the would-be mourners are critics who say the diversification principle failed spectacularly for investors just when they needed it the most — during the biggest market meltdown seen in generations.

After all, the idea behind diversification is that no two investments perform in exactly the same way at the same time. By mixing up the asset classes in your portfolio and diversifying within those asset classes, the idea is that you provide yourself with a cushion or shock absorber in the down times.

But then came the financial crisis of 2008 and suddenly there seemed to be no safety net. Just about every asset class — apart from government bonds and cash — got walloped. In the jargon of financial economists, those asset classes appeared to become much more "correlated".

But the appearance of rising correlations does not necessarily mean that diversification does not work. And you can prove that by considering what might have happened if investors had been less diversified than they could have been.

It's a point made by Dartmouth Tuck School of Business finance professor Ken French.

"Diversification still works," French explains, "and investors would have had even more uncertainty about the return on their portfolios if they had been poorly diversified."

French points out that diversification does not eliminate the volatility of the overall market. What it does do is protect against the additional volatility arising from the characteristics of individual firms or asset classes.

"It's that extra volatility that you don't have to have if you diversify well."

On the question of rising correlations in highly volatile markets, French notes that the return on any asset comprises two components — the market return itself and the return attributable to the specifics of the individual asset.

During the extreme volatility of 2008, the market movement became proportionately much more influential so that it appeared that individual stocks and asset classes appeared to be much more lined up with each other.

"What matters when we think about diversification is the firm-specific pieces, not the market piece," French says. "And we know that in these volatile periods, the firm-specific pieces also get bigger. So while it may look like the benefits of diversification have gone down, they have actually gone up."

These differences in the firm-specific variation in returns are what financial economists call "cross-sectional dispersion". And it is well established that just as market volatility tends to spike after periods of negative performance, so do the cross-sectional dispersions.

What this all means for investors is that the need for broad diversification both across and within asset classes becomes even more important at times of high volatility.

Reports of the death of diversification have been greatly exaggerated.


----------



## Marc (6 Jun 2012)

In December 1997 an opinion piece appearing in the Wall Street Journal by a prominent financial writer who claimed that the notion of broad-based international diversification of equity investments for US investors had been convincingly revealed to be little more than faddish "nonwisdom." He described a strategy of accepting market rates of return across a broad universe of countries as being little more than gambling and he had resisted suggestions from financial professionals to diversify globally, he said, smugly confiding that he had "no money in the former Yugoslavia, none in the present Argentina, none in the future Republic of Antarctica, none in Zambia, Belgium or Kazakstan.

At the time, the case for international diversification appeared questionable based on recent performance. For the period ending November 1997, the S&P 500® Index had outperformed benchmarks of developed country and emerging country stock markets by a wide margin over one, three, five, and seven-year periods. For the three-year period, annualized return was 31.05% for the S&P 500® Index compared to 6.19% for the MSCI EAFE Index (net dividends) and -7.24% for the MSCI Emerging Markets Index (gross dividends). Why bother investing in L'Oreal, Heineken, or Samsung when General Electric and Microsoft were showering shareholders with such impressive returns? In the author's view, "the notion that the US offers insufficient opportunity to diversify is absurd." A prominent mutual fund executive made a similar observation the following year, comparing investment opportunities in the US market to a prospector standing in "acres of diamonds."

The article went on to cite a prominent financial advisor who applied a globally diversified passive strategy for his clients, poking fun at his allocation strategy that "a robot could figure." The thinly veiled suggestion was that investors were ill-served by such advice.

The author cited poor disclosure, risky currencies, and weak legal protection of shareholders as reasons why US residents "can lead a happy investment life without leaving home." 

Perhaps so, but he was silent on the merits of this advice for citizens of other countries. Should Irish investors boycott their home market and also limit their holdings to US securities? 

If they did so, would their decision cause prices to fall in non-US equity markets, raising the cost of capital for local firms and hence investment returns for the remaining shareholders? Perhaps.

Since the article appeared in December 1997, global markets have had their share of ups and downs, but results suggest that excluding non-US securities from consideration may have unappealing consequences. For the ten-year period ending November 2007, annualized return for the S&P 500® was 6.16% compared to 9.00% for the MSCI EAFE Index and 14.76% for the MSCI Emerging Markets Index. Among nineteen major markets (EAFE constituents plus Canada), only one (Japan) underperformed the S&P 500® in US dollar terms over the ten years following the article.

Roger Lowenstein, "'97 Moral: Drop Global-Investing Bunk," Intrinsic Value, Wall Street Journal, December 18, 1997.

John Waggoner, "Send Your Savings Abroad? Conventional Wisdom Says Yes, Many Experts Say No," USA Today, July 6, 1998.

The S&P data are provided by Standard & Poor's Index Services Group.

MSCI data copyright MSCI, all rights reserved.


----------



## Chris (6 Jun 2012)

I think the whole debate comes down to one thing and that is whether you believe in the Efficient Market Hypothesis or not, and there is a very good thread on this where some of us debated it.
If you do believe in EMH then Marc's approach of large scale diversification is a good option.
If you don't then it is unnecessary overkill.

I fall into the second category, but I still believe in diversification. But I don't just diversify by holding x amount of stocks, I diversify by industry and geography. Usually this involves 5 broad industries with around 5 companies in each giving me about 25 stocks. Sometimes it's higher and sometimes lower, but that is the basis of my diversification.


----------



## Marc (6 Jun 2012)

Chris 

Zurich launched their 5star5funds on the same basis. Interesting that they concluded that 25 stocks resulted in insufficient diversification and subsequently increased this to 50 stocks.

So the challenge here is to test statements like this. I have already tested Zurich's 5star5 funds. Most of the returns can be explained by exposure to priced economic risk factors of market,size and value. 

The remainder is basically noise arising from the idiosyncratic decisions of the fund manager which on average are negative.

So, go ahead pick your best 25 stocks and I'll test your portfolio against an index portfolio with a similar size and value tilt and on average ill win. 

The more you trade in an attempt to get ahead the more costs you will pay and the more I will pull ahead.

This has nothing to do with the efficiency of markets and everything to do with what Bill Sharpe called the arithmetic of active investing. In aggregate we all hold the market portfolio. So before costs the average investor will earn the market return. After costs you will get less. The more you trade the worse you will do on average.


----------



## Monksfield (12 Jun 2012)

*Emh*

A recent quote from George Soros:

"I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them."

Without wishing to undermine all of financial theory (of which EMH has been a major pillar) I think it is time to give EMH a decent burial.


----------



## Chris (13 Jun 2012)

Marc, I am not talking about trading, in over ten years of investing I have made less than 5 sales. Rebalancing was the main reason in most cases as I had 2 investments increase at a large multiple. 

For my purposes 25 stocks has worked out as very good diversification for the past 11 years and I don't believe you can make judgments about my portfolio with any credibility.


----------



## Marc (13 Jun 2012)

Chris, I'm not making judgements about your portfolio, that's why I asked to test it. Any theory should be capable of being tested.


----------



## Chris (21 Jun 2012)

Ok, so rather than me giving you just 10 years of data which of course I could fudge in my favour, how about putting Buffett's portfolio to the test. Now he does have more than 25 stocks in his portfolio, but it is still minuscule compared to diversifying in the thousands, and his portfolio is a matter of public record.


----------



## Marc (21 Jun 2012)

Ok this is a good question and one worth looking at.

I am testing all data from Jan 1990 to April 2012 which is as much data as I have for everything I want to look at. Source: Bloomberg, CRSP, S&P, Fama/French reseach index data source Ken French's website

What do we know about Berkshire Hathaway. That it is a US$ large cap value investment.

So, if I test BRK/A against a single US large cap stock picked at random, I should have the same expected return but I have more volatility since BRK/A is more diversified.

Wal Mart vs BRK/A

*****Average annual return*** Volatility
BRK/A ***12.52%pa **********21.61
Wal Mart* 12.25%pa********** 23.30

So, as expected Wal Mart has more volatility than BRK/A but about the same return.

Now if I add a more diversified index which has a higher expected return, then I should get a better risk return trade off.

I consistently argue that small value is more risky than large value and therefore I should have a higher expected return than BRK/A if I buy a US Small Value index, but since it is an index, it is more diversified and therefore should be less volatile

************************Average annual return***** Volatility
Fama/French Small Value Index 13.92%pa ***************19.30

So, I can do better than Warren Buffet between Jan 1990 and April 2012 with less volatility.

Or I could use Emerging Market Large Value as my risk factors 

Emerging Markets Value Index 13.94%pa ** 24.86

Again I beat Warren Buffett but my volatility is higher since Emerging Markets are more risky than developed markets.

So, I conclude that a diversified portfolio managed by one of the greatest investors who ever lived is less volatile than a single stock picked at random. 

But by diversifying my portfolio across priced economic risk factors I can select a portfolio that beats even Warren Buffet and which is less volatile.

The model has an R2 of 0.26 which means that this model explains 26% of the variation of the returns in BRK/A suggesting that there is a large ideosyncratic term around the decisons made by the management.
Equally the model explains 28% of the variation in the returns of Wal Mart.
The R2 for the Small Value research index is 0.99


----------



## Sunny (21 Jun 2012)

A fund with 11,000 shares? Seriously??

A couple of points.

a) No fund manager has the manpower to adequately manage the risk of 11,000 positions in one fund. What sort of analysis or management are these guys claiming to do?
b) I find it hard to believe that correlation wouldn't become an issue with 11,000 shares
c) Surely with 11,000 shares, whatever gains are made by individual shares are almost meaningless because your capital is psread so thin. You might not lose much money but find it hard to see how you can make money.
d) Diversification is a good idea but statistically, how much are you reducing risk by when you add the 5000th share, never mind the 11000th share.


----------



## ashambles (21 Jun 2012)

A fund of with exposure to 11,000 funds is a tracker (i.e a fund buys all the stocks in an index such as the NASDAQ  or a combination of indices) , I’d a quick search for the number (as I suspected it must be some well used approximation for index funds) and it comes up a bit - someone talks about it here. http://finance.yahoo.com/blogs/breakout/3-signs-gambling-not-investing-143026282.html



> Matson advises that instead of hand-picking your portfolio of five to ten stocks, you must be much more diversified with exposure to 11,000 global stocks.
> ..
> It's a far better strategy to own global index funds with low cost and widely diversified risk. "Remember, the returns come from the market, not the individual investor.


  Buying index funds only is a perfectly good strategy – whether they track 11,000 companies or 100, indeed much advice now is to switch to index trackers and avoid actively managed funds as they’re seen to underperform the markets on average – partly due to their charges.


----------



## Marc (21 Jun 2012)

Thanks ashambles nicely dealt with. Although Mark Matson owes me a pint for the plug next time I see him.

Regarding the 2nd and third points in Sunny's post.

The correlation with the "market" approaches 1 (i.e perfect correlation) as more stocks are added. So, the stock specific risks reduce (Enron, Worldcom, Anglo Irish, Swiss Air,Woolworths,Polariod,Commodore Computers,Pan Am and I'm only trying to list big "safe" companies you might have heard of ) to the point where you are really only left with "systemic" or market risks. These are risks you cannot avoid by diversification and are the risks that impact society at large.

Finance theory says that the market does not reward risks you can diversify away - why would it? The real driver is the growth of capitalism which over time is positive.The expected equity risk premium is probably around 4% above the risk free rate.

So, the third point is that your return comes from capitalism inc rather than company inc. Company inc can go bust but capitalism inc probably won't.

Think of it this way. Would you sell your house, go to Vegas and put it all on red? 
No of course not. So, why do the same thing gambling on the prospects of 1,2,5, 10, 50, 100, or 1000 stocks when you could hold 10,000 or more.

Private investors should not invest in individual companies because for almost all of us the downside risk is too great. 

Personal story.

In 2007 I was chatting to a relative who had thousands and thousands of Royal Bank of Scotland shares. I recommended selling and diversifing. He gave tons of reasons not to (dividends are great, didn't pay much for them as employee share save, so big capital gains tax liability payable personally if sold and so on and so on) until of course now hundreds of thousands if not millions worse off.

Don't do it. You don't need to and the downside isn't worth it.


----------



## Sunny (21 Jun 2012)

No one is suggesting that people should invest in one company. I simply fail to see what you are achieving by investing in 11000 stocks rather than say 1000. The difference you have made to the downside risk is minimal I would imagine. As I said, what difference does adding the 11000th stock compared to if you just stopped at 5000. Fair enough, you just want the market risk and not the individual stock risk but does the fund of 11000 stocks do that any better than a fund of 1000 shares. Maybe it does but I haven't seen the research saying this is the case.


----------



## Marc (21 Jun 2012)

Actually there are plenty of posts on here saying you only need to pick 25 stocks. In some cases just 10 Irish stocks!

Look at it this way.

There are about 5000 stocks listed on the NYSE so a 5000 stock portfolio would equate pretty closely to the US market. 

The US is about 40% of the world market capitalisation.

So by owning 5000 stocks you are "choosing" to ignore 60% of the market.

Which bits do you want to leave out?

All of China and Russia? All of Europe? All of South America?
India? All of Africa? Australia? (with apologies to anyone I missed)

That is the scale of what you do when you "just" buy 5000 stocks.

Interesting that in a sense the debate has now moved onto why not just 5000 stocks. In my experience most investors hold around a couple of hunded.


----------



## Chris (28 Jun 2012)

Marc, my suggestion was. It to compare the Berkshire Hathaway stock to other stocks or a basket of stocks. My suggestion was to compare Berkshires stock portfolio to a hugely diversified portfolio. Buffett himself has repeatedly said he would not buy Berkshire on a value basis, and Berkshire is a lot more than a stock portfolio.
Records for Berkshire's stock portfolio go back decades and are public record. If you are right then your highly diversifies portfolio will beat Buffett's far less diversified portfolio. I for one doubt that.


----------



## Marc (29 Jun 2012)

Chris,

Returns are driven by exposure to risk.

If you buy Berkshire Hathaway you are taking on more risk than the market portfolio.

So, you might do better or you might do worse. You are also taking on manager risk - Buffett can and will die. You are more uncertain of your outcome compared to the market portfolio.

By testing the historical performance I showed that anyone could have done as well as Buffett just by taking on asset class risk.

But im not saying a market portfolio of tens of thousands of stocks will always beat Berkshire Hathaway. That is missing the point .

Im saying that if i want to do as well as berkshire i have to take on as much risk and to do that i can buy a highly diversifed portfolio of an asset class that I can expect to perform as well as Berkshire. This is what I looked at above.

The emerging market large value index has 1872 stocks in it and outperforms Berkshire Hathaway.

It does this because it carries more risk, but it is still highly diversified across that asset class.

But if I hold a market portfolio and berkshire is holding a more concentrated portfolio then it is more risky than the market portfolio and therefore of course Berkshire could outperform since it is taking more risk. But it could also underperform. Whereas a market portfolio by definition cannot underperform the market I.e itself.

So i can beat berkshire by loading up on risk factors as I have shown. But there is no guarantee that these risks will pay off, that is the nature if risk, or I can hold the market portfolio and have no risk of underperformance.

Whereas by holding the market portfolio I have the certainty of the market return. I dont have that with Berkshire Hathaway - even with Buffett at the helm and I certainly don't without him which is why holding the market portfolio is a better investment than holding 25 stocks picked at random.


----------



## Chris (5 Jul 2012)

You are still missing my point Marc. You keep comparing a marjet portfolio to Berkshire shares. Berkshire is made up in part of a stock portfolio, which is published quarterly, and then made up of many fully owned companies with the largest being Geico. The company's share price is just people's evaluation off all the assets, not just the share portfolio.

What I want to see is a comparison of the share portfolio to a huge market index, as you suggested earlier that you could show that in some way my portfolio will not have performed better than some weighted index.

I also assume that by taking on more risk you are basing this on measurable volatility, correct me if I'm wrong. This is something I have disagreed with you on before, in that I don't think you can simply measure risk by measuring volatility; risk is far more subjective than that. I would be much happier with a carbon copy of Buffett's relatively small portfolio than with a Dow or S&P index, as I would deem it a lot less risky without all the banking and Facebook and RIM and LinkedIn crap which I wouldn't touch with a barge pole.


----------



## Marc (8 Jul 2012)

Chris,

We seem to be at crossed purposes here.

Characterizing portfolios is traditionally the work of securities databases and painstaking fundamental analysis. We know models aren't reality, and that outcomes certainly differ (especially in the short term) from the results predicted by models. But much of investing is about creating structure based on a logical and empirical "fit" with historical experience. 

I am describing a three factor model that narrows the variables that describe investment returns in any stock portfolio—the variables that investors should focus on managing. These are the “risk factors” I was referring to and they do not necessarily relate just to standard deviation which is one of your core criticisms.

The factors are “market” Stocks minus t-bills, small cap minus large and value minus growth

The three-factor model reads a time series of returns, measuring the sensitivity to each factor and assigning a percent to the common movement. 

Investors can tilt their portfolios for a higher expected return than the market by increasing their exposure to the small or value risk factors or both.
But they don’t need to hold a concentrated portfolio to achieve this. By overweighting either or both the size and value premiums investors have a higher expected return than the market portfolio but it is still possible to achieve this and hold thousands of securities.

Equally , if you present a concentrated portfolio of “winning stocks” it is possible to compare this portfolio with the risk factors and determine how much of the variation in returns can be explained by exposure to these common risk factors.

Hence my point is that if you did better than the market portfolio you probably took more risk by which I mean you probably had more exposure to small stocks, value stocks or both. These are compensated risk factors – compensation for higher risk which you cannot get rid of through diversification. 

But if you only held 25 stocks you also had uncompensated risk, risk you were not rewarded for taking because you could have diversified it away simply by holding more securities.


----------



## Chris (11 Jul 2012)

Marc, you always make excellent points, but we really are at a crossroad here. I simply do not believe that you can measurably quantify risk or even generalise what is risk. Yes, my portfolio did better than the market in the last ten years because I generally stick with value stocks. But in my subjective evaluation, especially in the last 4 years, I bieve I have been taking on less risk by selecting the value stocks that I did.
Another example would be that in my opinion having less than 20% allocated to precious metals is a big risk as is investing in pretty much any government debt. But these very actions would be looked at as very risky by most people; I just happen to disagree.


----------



## ringledman (12 Jul 2012)

Chris said:


> Marc, you always make excellent points, but we really are at a crossroad here. I simply do not believe that you can measurably quantify risk or even generalise what is risk. Yes, my portfolio did better than the market in the last ten years because I generally stick with value stocks. But in my subjective evaluation, especially in the last 4 years, I bieve I have been taking on less risk by selecting the value stocks that I did.
> Another example would be that in my opinion having less than 20% allocated to precious metals is a big risk as is investing in pretty much any government debt. But these very actions would be looked at as very risky by most people; I just happen to disagree.


 
Chris I think the models that the financial industry has developed over the past 50 years or so for the measurement of risk, asset allocation and the like are in need of a serious rethink. I question whether we can truely measure and magage risk in the first place in our portfolios. Certainly not in the way that a large swave of the financial industry think.

Howard Marks coceptualises excellently on these subject in his book 'the most important thing'.

Personally I believe that behavioural economics will come significantly to the fore in the future for the remodelling of risk.


----------



## Monksfield (15 Jul 2012)

I would go beyond Ringledman in terms of the need for a fundamental re-think ....it is of financial theory not just the models. Marc makes lots of good points but is still grounded in EMH.

The frailities of human behaviour (and probably the excessive power and greed of Wall Street) trump the theory.

As for the original question,25 stocks would diversify away an awful lot of market risk.I am unwilling to say how much because I don't believe in any of the models.


----------



## Duke of Marmalade (7 Aug 2012)

It is reasonable to posit that diversifiable risk will not be rewarded by the market.  A simple model - market risk is 20%, individual stock risk is 30% i.e. an excess 10% idiosyncratic risk which brings no reward.  Using the square root rule we would get the excess risk on 10 stocks as c.3%, 25 stocks 2%, 100 stocks 1%, 10,000 stocks 10 bp.  If there are any nagative factors to more diversification, e.g. costs for an individual's portfolio, it can be seen that diversification will quickly give diminishing returns.

The real fly in the ointment in all this is exchange rate risk.  Exchange rate risk (as oppposed to currency risk) is a zero sum game and hence is not rewarded by the market.  Marc's argument would seem to be that one grand global portfolio is suitable for all investors.  This is clearly not borne out in practice, there being a huge divergence between the typical US, UK, Japanese, German etc. investors.

A portfolio of 11,000 stocks must surely bring in a large chunk of "unrewarded" euro exchange rate risk.


----------



## Marc (5 Sep 2012)

Here's an interesting statistic

During the bull market of the 1990s 22% of all US stocks (that's a total of 2,397 companies that were in existence for the whole decade) lost money. Not in real terms in absolute terms they were worth less at the end of 10 years than at the beginning.

How do you avoid the risk that over a fifth of all US stocks can go down? 
Over this same period Japan went down dramatically. How do you avoid the risk of buying the wrong countries?

Surely the answer here is diversification broadly across asset classes and countries.


----------



## Marc (17 Nov 2012)

http://www.sensibleinvesting.tv/Default.aspx


----------



## darag (20 Mar 2013)

> Don’t overdiversify
> While portfolio diversification can improve your investment performance, it does have limits and is not without drawbacks. Research suggests that 90 per cent of diversification benefits can be obtained in most markets with a portfolio of just over 20 stocks.



I disagree strongly with this claim and have been meaning to say something on it for a while.  I believe a more extreme version used to be in the Guide?  Recommending the top 10 Irish stocks?

The problem with the analysis which "proves" that you only need 10 or 20 stocks to achieve 97% (or whatever) of the diversification benefit is that it based on comparing volatility of the basket of 10 (or 20) stocks with that of the entire market over a year.  The demonstration may be convincing but is does not constitute validation for the 10 or 20 stocks claim when combined with a "buy and hold" recommendation.

Simply because volatility is does not "scale" with time.  If your holding period is 10 years for your top ten stocks, then the excess volatility (i.e. risk) over that of the entire market grows considerably.  The only way to get the theoretical "protection" would be to re-balance your portfolio every year.

And the longer the period, the worse it gets.  Imagine if you put your wealth into the biggest 10 Irish stocks in 1983 with a buy and hold plan for 30 years.   Your portfolio would likely be in a sorry state at this stage.  Unfortunately the Irish Stock Exchange website provides painfully poor access to their data, so I cannot demonstrate this directly but intuitively, it's clear that a bunch of the Irish companies from 1983 in your portfolio would have gone bust or been taken over for a pittance, etc.

Another take on the subject is here http://www.efficientfrontier.com/ef/900/15st.htm.  This article also provides some interesting history on the development of what he calls the "15-stock diversification myth".  (This guy's articles are excellent by the way it's well worth browsing through his archive.)  To summarize roughly; 3 quarters of randomly selected 15 stock portfolios under-perform the US stock market over a 10 year period.

I could understand why holding a limited basket of individual stocks might have seemed like the most effective way of gaining exposure to stock market returns in the past.  But since you can get diversification almost for free now in the form of ETFs, it is very poor advice to recommend not availing of cheap and easy diversification.  I have simply no idea what "drawbacks" Terry Smith could be referring to.

From my experience, ETFs are less hassle to buy and hold; they  automatically re-balance and collect all the dividends for you.  Dealing with the corporate actions of 15 or 20 stocks is a pain in comparison.  And the big index ETFs have some of the smallest spreads (which is a tax on investment) in the equity markets.

If you want equity like returns and assuming predicting the future is not possible, you should concentrate on reducing fees and volatility.  The simplest way of reducing volatility is to increase diversification.  As far as I can see, you can never have enough of diversification particularly if it is almost free like it is with ETFs.


----------



## Marc (20 Mar 2013)

This post has been moved from another thread


----------



## darag (24 Mar 2013)

Hi Marc.  I think we are in complete agreement about diversification.  What is surprising is that this opinion seems to be in a minority here.

I've searched that thread for the downsides to "too much diversification" and I can find very few actual specifics on what these supposed downsides are.

First of all, the discussion about EMH (and related) is a complete red herring or at least a completely separate argument.  You either believe in passively exposing yourself to the equity markets or you don't.  If you fundamentally believe that you can do better with your own research, then holding the top 10, 100 or 10000 stocks are all equally poor investment strategies.  In other words, if you are a stock picker/market timer, then the entire argument (of how many stocks you should passively hold) is irrelevant to you.

Many express the the belief that extra diversification is unnecessary - e.g.


> ...it is unnecessary overkill.


Which simply expresses the belief that there is little value in more diversification without explaining what the "downside" is.

Some question whether there is an efficient mechanism to achieve such diversification but in fact as you point out, there are cheap and very simple ways of achieving diversification across thousands of global stocks.  For example, I have shifted all my equity exposure into the Vanguard VT ETF.  This is certainly easier than holding 10 individual stocks: I now only have a single dividend to deal with, I get free and automatic re-balancing and tracking my "equity portfolio" is trivial.


Another argument demonstrates a lack of understanding of the properties of volatility and correlation:


> I find it hard to believe that correlation wouldn't become an issue with 11,000 shares


Unless the stock you add to your portfolio is 100% correlated with a stock you already hold, you can only reduce the risk of your portfolio.  And if it is 100% correlated, you do not increase the volatility of your portfolio assuming proper balancing.


One issue which was raised is that of exchange rate risk.  This might deserve a thread of its own.


> A portfolio of 11,000 stocks must surely bring in a large chunk of "unrewarded" euro exchange rate risk.


I had long worried about exchange rate risk as it commonly given as a reason to avoid investing globally (or at least limit your global exposure).  However when I tried to measure this risk, I could not find it.  For example,  take the Standard and Poors 500 as a proxy for the US market (because the data is so readily available - e.g. from yahoo finance) for the last ten years.  The closing prices in USD actually have MORE volatility than the same closing prices expressed in EUR.  In addition the returns are slightly lower denominated in EUR.   So in fact, for a Eurozone investor holding the S&P500 for the last years was a lower risk (and lower reward) proposition than it was for a US resident.  This example doesn't constitute a general proof, but for me it is relevant given how important I believe having exposure to the US equity markets is.

And I sure am glad that I ignored the 10 Irish stocks recommendation when I first started to put money into equities (buying index ETFs instead although I was poorly balanced globally).


----------



## cremeegg (25 May 2013)

Just how many angels can dance on the head of a pin.

Either buy the market, through an EFT or be a stock picker.

If you are a stock picker you will probably loose money, but if you have time, ability and luck you might do well.

On average you cannot beat the market, but we all believe that we are better than average.


----------

