Portfolio Diversification vs. Stock Picking (Part 2)

Categories : Financial, News
January 11, 2023

Portfolio Diversification is rarely disputed as fundamental to investing success. Problematic, however, is finalizing a definition of the term “Diversify.” To many, the answer lies in the number of individual stocks held in an investor’s portfolio. Not only is there disagreement as to “that number,” but in practice, the very premise is debatable.

Prominent among early papers on the subject is a study by John Evans (Evans) and Stephen Archer in the 1968 Journal of Finance. Versions of their results permeate much of today’s financial literature. Evans concentrated on stocks, and specifically the number needed to determine the best 1-year results. Disputed conclusions in Evans included:

  • Stock index funds are unnecessary, as 60 to 80 stocks can produce results similar to indexing
  • Active portfolio managers should only hold 20 to 30 stocks to prevent “de-worsifying” into 60 or more stocks
  • “Do-it-yourselfers” should hold small handfuls of stocks, as they can’t pay sufficient attention to a greater number of holdings

Read that list again, and if you understand the logic, please notify us, as we remain confused by their conclusions.

Unfortunately (in my opinion), far too many investors, apparently in lockstep with their advisors, believe that Portfolio Diversification may be satisfied by the number of individual stocks held in an investor’s portfolio.

Thankfully, there has been extensive research on this very subject, mostly disputing Evans. One recent synopsis is by Yin Chen (Chen) and Roni Israelov of advisory firm NDVR in Boston. While Evans concentrated on one-year volatility, Chen looked at total return over a 25-year period.

Chen found that portfolios holding more stocks were not ever more volatile than those with fewer holdings. Logically, we need to understand the value of experiencing more or less volatility. Greater volatility produces a larger upside potential, but also a greater downside risk. For reasons both mathematical and psychological, less downside risk is most investors’ preference over time, so long as upside potential is sufficient. Losing portfolio value is more painful for most investors than gaining a similar amount is rewarding.

No pure stock portfolio can match results from fully Diversified Portfolios utilizing multiple Asset Classes, and no number of individual stocks will produce better results, in the absence of unusually good luck.

Simply put, whether 20 stocks, 60 stocks, or 500 stocks, the portfolio remains under-diversified in the absence of multiple Asset Classes. We should all focus on the overall process of Portfolio Diversification.

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