The 5 Ways Diversification can kill your Portfolio Returns

Given that the law of diversification is about as close as one can find to a consensus belief amongst investors your portfolio is most likely to have at least a few stocks in it. But what if I was to tell you that the level and style of your diversification could be putting your capital significantly at risk?

The truth is that most investors don't know anything more about diversification than you "shouldn't put all your eggs in one basket". Spending some time trying to understand the ways you might be shooting yourself in the foot could seriously enhance your portfolio returns and stop catastrophic risk. But frankly who would want to trudge through all those finance journals?

Well, err… we did and here's what we've found…

In 1977 Elton and Gruber published a landmark research note that showed that most of the gains to be had from diversification come from adding just the first few stocks. Adding 4 more stocks to a 1 stock portfolio gives you 71% of the benefits of diversification of owning the whole market. Even owning just 15 stocks brings about 87% of the benefits of a fully diversified portfolio.

Not only that but the more stocks an investor owns, the more likely they are to bleed away performance in higher transaction fees as the relative size of their orders are reduced in relation to the fixed costs of trading. These higher transaction costs significantly reduce long term returns especially in smaller portfolio sizes.

So if your stockbroker has you in a portfolio of 35 stocks in the name of diversification you can always quote Elton and Gruber while firing him for someone cheaper and (dare I say it) more exciting.

But hold your horses… William Bernstein, the renowned financial theorist, hit out at this '15 stock diversification myth' with a smartly argued case that while investors who only own a few stocks may have reduced their portfolio volatility the real risk they face is of significantly underperforming the market by missing the winners.

Bernstein showed that much of the overall market return comes down to a few 'super stocks' like Dell Computer in the 1990s which grew by 550 times. "If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market". As the odds of owning one of these super-stocks was only one in six Bernstein argued that you could only mitigate the risk of underperformance by owning the entire market! So maybe that stockbroker was onto something after all?

Of course intuitively there comes a point when, by owning too many stocks, the impact of finding a winner has a negligible effect on your portfolio which rather ruins the joy of it. In a 30 stock portfolio any stock that doubles will only add 3.33% in performance which is frankly pretty dull. Peter Lynch once mused "It only takes a handful of big winners to make a lifetime of investing worthwhile" - just make sure they have that impact!

Portfolio Theory has shown that there's an ideal level of diversification between 2 stocks which both minimises risk and maximises return - ideally you want to own stocks that zig while others zag to achieve this. But while this may be easy in theory it seems to be way beyond the ken of most investors.

A 1990's study of study of 60,000 private investor portfolios by Kumar and Goetzmann at one of the US's biggest discount brokerages found that investors on average owned only 4 stocks. Not only that but these stocks had price movements that were highly correlated. As a result their portfolios were almost as risky as the assets held within them completely negating the benefits of diversification ! This type of behaviour has been seen time and again with the massive overweighting of internet stocks through the 1990s and of resources stocks today.

Higher portfolio volatility puts far greater emotional pressure on less sophisticated investors contributing to poorer decision making and worse returns. The average portfolio in the study underperformed the market by between 0.5% and over 4% annually!

So, you've decided you need to own more stocks? The fund management industry is there to help… or is it? I joined a friend to meet his portfolio manager to discover that he had been shoved into a portfolio of 30 funds. Not stocks - funds! Each fund within it contained between 50 and 200 stocks each and most of it was in the UK.

You'd think that with probably 1000 stocks or more in the portfolio his performance would be similar to that of a tracker fund? But no, it displayed a massive underperformance over 5 years… far greater underperformance than due to fees alone. Why?

What so few investors in funds seem to understand are the hidden costs of owning mutual funds on top of the stated expense ratios. These costs have been shown can drag another 3% per year from your fund returns! The details are for another day, but cash drag, soft dollars, tax costs and other hidden fees are crushingly expensive. If Index Tracker funds have been shown to beat 75% of actively managed funds over the long term mainly due to a massive reduction in these costs - why take the risk?

Once upon a time investing in foreign markets and odd commodities brought a good hedge to portfolios as these assets returns were uncorrelated with local stock markets. But in the last 20 years financial innovation has marketed ETFs, hedge funds and structured products to a globalising financial customer base allowing almost push button exposure to exotic asset classes and advanced alpha extraction techniques.

The net effect is that different markets and asset classes now regularly trade as baskets and the correlations between them have risen dramatically. Unsurprisingly the benefits of diversification are much smaller in the global marketplace than ever before.

Give this environment a bad market like 2008 and financial contagion can spread like wildfire, sparing almost no asset class, ruining portfolio returns and striking a spear into the heart of diversification theory.

It may be that the only real hedge these days is a completely new asset class - volatility itself. A recent study showed that adding a 10% position of the volatility index (VIX) to an equity portfolio outperformed the market index while reducing risk by 25%!

In our journey we've discovered that you may only need to own a few stocks, but that you can't own enough; that left to pick your own stocks you might not pick the right ones; that you may well underperform if you own managed funds; and owning other asset classes may not bring quite the hedge you'd hoped for. It's pretty confusing granted, but there may be a simple road out.

Owning a few global tracker funds in varying asset classes while hedging with the VIX can spare you fees and the risk of underperformance while bringing volatility protection, and allowing a minority allocation to your own 5 to 8 best stock picks will possibly save your sanity from complete boredom while just possibly bringing the outperformance you hope for… Of course while Warren Buffett might caution that 'diversification is a hedge for ignorance', the smartest move of all may be to accept that you just aren't that smart!

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