Is diversification dead? It largely failed us in the 2008-2009 financial crisis, but if you held on for the long haul it did breathe life back into your portfolio on the way back up.
A perennial question is how much diversification is enough? If you’re invested in mutual funds and ETFs, these are by definition already diversified, at least within the sector or group or style that they represent. You could own a fully diversified portfolio with only 5, or arguably even 3, ETFs.
Stocks pose a tougher challenge since they represent individual companies, and as such, might be like flying in a 10-row airplane or even a helicopter as opposed to the large, stable feel of a 747. You feel all the turbulence of the stock market, whereas in an ETF you’ll notice the turbulence too, but you will have this added feeling of insulation from it.
Not so long ago I was watching an interview on BNN with one of Canada’s billionaires, Michael Lee-Chin. Lee-Chin is an entrepreneur in the full sense of the word, owning and building various types of businesses. He primarily built his wealth, it seems, from an investment company he ran – AIC – which he later sold off after the 2008 financial crisis scared most of his investors out of the market.
One comment that struck me from hearing Lee-Chin is that in his view, you only need 15 stocks to be fully diversified. To me, 15 sounds a bit on the low side, although I have heard other analysts who would say about 20-25 stocks would do it. 25 stocks sounds much more reasonable when you consider how many great names there are just in Canada alone. Add in a handful of the U.S. blue chips and some top-tier UK, European and Asian stocks, and you’ll reach 25 in no time.
But Lee-Chin is more of a coveter than a hoarder. He seems to really, really, love the stocks he picks and he holds them forever. He is not a trader. It sounds as though he isn’t planning to sell any of his stocks. In this respect he might have something in common with Buffett in the sense that Lee-Chin seems most interested in buying businesses.
One stock Lee-Chin really likes (if he didn’t outright “recommend” it)? Manulife (TSE: MFC)! After all the recent troubles with its capital fortressing and dividend cuts, Lee-Chin is hanging on “without a doubt” because it is such a great company.
It’s a bit inspiring to have such a now seemingly “old-school” attitude towards one’s stocks in a climate where the mantra on the street seems to be “buy and hold is dead.” But Lee-Chin is a successful billionaire and philanthropist. I’ll think twice before dismissing his comments.
So the question now is, what 15 stocks to own? I already own well more than that, and I don’t plan on selling any just to meet a minimalist stock challenge of sorts, but I certainly can think about giving my attention to a select few. I think it might be wise.
What would you pick? Your top 15 stocks? Your top 15 favorite businesses? How much of that would you allot to international companies?
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{ 10 comments }
Maximum stock portfolio diversification benefit is obviously achieved by owning all the listed stocks, but for direct investment the transaction costs mean that for small investors probably 8-12 medium-large stocks is sufficient to capture most of the risk-reduction benefits of diversification. A cost-effective alternative is to invest in stocks via an ETF or an index fund.
However, aside for the benefits of diversification within a stock portfolio, you should also consider the benefits of asset-class diversification in general. A mix of stocks, property, bonds, cash and a smidgen of alternative investments such as precious metals, agribusiness, hedge funds, art etc. can help reduce volatility (risk) without reducing expected returns.
Yes, I automatically include asset allocation as a component of diversification. Full diversification also includes diversification over time, i.e., dollar cost averaging. And,of course, diversification of income streams!
As a financial planner for many years now I have been asked this question many times. One of the fundamental questions I ask in return is – how much risk do you want to take? And what kind of investor are you? If they are passive – absolutely ETF’s are the way to go and I usually recommend no more than 5. If they are more active then rather than saying how many should you own I recommend looking at what % of a portfolio is invested in a single stock or bond. If they are very high risk thay may have 5 postions total – 3 stocks and 2 bonds. If we say that 60% is equities and 35%in fixed income then I would reco no more than 5% in any one stock or bond. So this would give you MIN 12 stocks 7 bonds and the balance in cash. The theory behind this is if one postion absolutly tanks than you have lost a MAX of 5%. Part two of this is that you have to look at all your portfolio’s as one great big one. One client had a total of 32% of his total assets in one bank stock without even knowing it as it was spread out across 9 accounts (RSP, spousal, non-reg, ESPP…)
Too many times I have found people to have fallen in love with a stock and married it! A stock doesn’t love you and really doesn’t care if you lose your money. Just because a company is great doesn’t mean you will make money. Just my 1frankthought (twitter)
Frank Wiginton
Good point about having the same stock scattered across many accounts. You really need to find out exactly what your mutual fund holds – you might be surprised! In Canada especially there could be a lot of repetition since most index-based funds are going to hold the same key bank stocks, etc. etc.
15 seems like a good maximum. 20-25 or more, then you’re effectively managing your own mutual fund and it becomes close to a full time job.
I think diversification may be more important in regard to the non-stock portion of a portfolio. As to the stocks themselves, they tend to move in a herd so it may not matter whether you own 5 or 50. On a major downswing, what you’re holding apart from stocks becomes more important. And isn’t diversification more about prodecting from a stock slide?
Thanks for the post.
I agree there are a number of ways to look at diversification with respect to the type of investments (equities and fixed income) and then the sectors your are in and then the regional/country of the investments.
With our current global economy though, there are investments that become global just by the nature of business. If you take KO (Coca Cola), is that just a US company? or is it global and it covers your international equity. The group RRSP plan at our office defines international as a different market than US. For diversification, you would have to do Canada, US and then International. I just reviewed my diversification within that plan and I have 30% income fund, 40% balance fund and 30% cdn equity. The balance is actually a mix of income and equity and in the end I have 40% income and 60% equity. Interestingly enough, it matches the 2025 life plan fund in terms of allocation. I am actually pretty conservative and the options are actually very few. There isn’t even an option for sector investing. With respect to my overall portfolio, I consider my group RRSP a conservative investment in general without referring to it as fixed income. I would say that I am overweight in financial in the end (if you also include insurance companies). Because of the smaller investment amount I have outside my RRSP at the moment, I have only a handfull of investment in order to do a meaningful purchase. It would not make sense to by 25 companies at 1,000$ in each and because of that, I have fewer which reduces my ability to diversify at the moment. I pick equity over ETF (which would be kinder to smaller amounts) because they are good purchases so I am defying diversification because of good investments available. As an example, one purchase I did in early 2009 is BNS @ 27$. I bought a fair amount which is nearly 20% of my non RRSP portfolio based on the purchase price. With the current appreciation, it’s quite lot. Sell or keep? Based on my purchase price, I have a really good dividend and that was my main goal. So I am keeping :) I think it’s important to not loose sight of that.
It’s a long comment, but I have been thinking about diversification for a little while … and what it means to me.
@ ME – Nice post!
I think about 20 blue-chippers is good diversification, otherwise, you’re diluting your investment portfolio with some weaker stocks. To say that you need 30 or more, is IMO, way too much. Especially if you want to fully DRIP these, who has that cash? :)
In Canada, pick 3 or 4 financials; pick 3 or 4 energy/utilities, a few materials, a couple of industrials, telcos or consumer goods, and you’re set. That’s pretty much the TSX index at a glance:
• Financials ~ 32%
• Energy ~ 26%
• Materials ~ 20%
• Industrials ~ 6%
• Consumer Goods ~ 5%
• Telecommunications ~ 4%
• Other sectors / the rest ~ 7%
If you wish, sprinkle a lil’ JNJ, KO, PG,, MCD or MMM as US stocks into your RRSP to avoid the withholding taxes, and you’re done. ETF everything else :) This way, you help yourself with diversification across many accounts. ETFs are certainly a great vehicle to provide asset transparency – I love them for that and their distributions. Cheers!
From most of what I read and the investing I have done 15 stocks seems to be really on the high number. I think the ideal is to invest only in the amount of companies you can adequately keep track of, otherwise you may be hurting yourself. As far as risk is concerned we’ve seen that even different sectors in the short term cant necessarily protect you, but in the long run it really shouldn’t matter as long as your investing in very good companies with good growth. Once again keeping up with the companies is paramount, and investing in what you know as Peter Lynch and Warren Buffet have said. Also risk may be better served by adding other forms of investment such as gold, bonds than necessarily holding a bunch of compaines in different sectors.
For more ideas check out “Investing the Last Liberal Arts” by Robert Hagstrom
Just because this guy was a successful entrepreneur, doesn’t mean he understands anything about investing. I have learned that one should not get “married” to a position. For example I like JNJ, PG, MCD,KO, WMT etc, but if any of them start dissapointing me, I would show them the door. I have approximately 40 individual stock positions, which I do research on. Anyone who claims they focus on 10 -15 stocks are doing so in order to “outpeform the market”. It is not smart to hold 10-15 stocks even if you know everything about them. Things happen that noone could have predicted, stocks could gap down on bad news, oil spills happen etc etc.. A one weak link in a portfolio of 30-40 stocks won’t be felt too bad. A one weak link in a portfolio of 10-15 stocks will hurt bad.
I would count the diversification rule to be around distinct business sectors.
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