Please refer to Important Disclosure Information at the end of this research note
I was reading a Morningstar article this morning titled “Diversified Exposure to Quality Stocks.” I liked the premise of the article - “good companies don’t always make good investments, but they may offer attractive returns relative to the market over the long term when they are trading at reasonable valuations.”
But I'm having trouble getting comfortable with the number of holdings in the featured ETF: iShares MSCI USA Quality Factor (Ticker: QUAL).
QUAL has more than 120 holdings - that's a 100 stocks too many.
In all fairness, this ETF appears to have handily beaten the S&P 500 over the last two years. But here's the rub: if you had built an equal-weighted portfolio with only its top-10 holdings, you would have achieved most, if not all, of the gains in that time period, with much less work.
The issue with over-diversification (“di-worsification")
Say you did all that bottoms-up fundamental research to find a stock to fill that 127th slot in the portfolio. If that stock doubled in value over the next 5 years, then your entire portfolio would only gain 0.78% due to that stock’s returns. That’s a lot of homework for a home-run investment with a relatively immaterial overall gain.
So what is adequate diversification?
It has been shown, empirically, that diversification can be achieved with a 30-35 stock portfolio (One source is Meir Statman’s “How Many Stocks Make a Diversified Portfolio,” Journal of Financial and Quantitative Analysis 22, Sept 1987). With around 30 stocks one can eliminate more than 95% of non-market (“idiosyncratic”) risk of owning a single stock.
But coming up with 30 high conviction ideas is hard (see Buffett’s quote at the beginning of this note) and each position may still be too small to make an impact on your portfolio.
Would you put 40% of your portfolio in a single stock?
It may come as a surprise to some that, back in the ‘60s, Buffett famously invested 40% of his portfolio into a single stock – American Express.
Some may view this as irresponsible but let’s review Buffett’s record for a second. During the period 1957-1968, the Buffett Partnership produced 25%+ compounded annual returns! The performance was relatively consistent throughout that period. That doesn’t seem irresponsible to me. A dollar invested in the partnership at the beginning would be worth 10x over that 10-year period.
How does one reconcile Buffett’s investment approach with the “prudent” approach by some Financial Advisers who (inadvertently through over-diversification) may advise their clients to own more than 100 positions in their portfolio?
building an efficient portfolio
There are many ways to build an efficient (read: concentrated) portfolio with enough diversification to mitigate the all-important “errors of commission” risk, without sacrificing returns.
- Equal weighting is one approach. For a 10-stock portfolio, assign a 10% weight to each position. If your 10th holding doubles in value, you make a 10% overall return. If your 10th holding is cut in half you lose 5% on your portfolio, which isn’t great but you live to fight another day. Not bad.
- A probability-weighted methodology like The Kelly formula, is another approach.
The Kelly Formula: The Layman's Version
Developed by John Kelly, this formula provides a simple tool to think about portfolio sizing. For more on Kelly, I refer you to William Poundstone’s most enjoyable book Fortune’s Formula.
Here’s a simple example to illustrate the idea.
- Say, stock A has “five-bagger” potential with a 15% probability, but could very well be a zero.
- Stock B has a 50% probability of going up 50% and a 50% probability of going down 20%.
The Kelly Formula says we should not invest anything in Stock A!
Simply put, the potential gains are just not exciting enough to compensate us for the risk of losing all our money. According to Kelly, Stock A needs to have “seven-bagger” potential to be worth our time and money.
The Kelly formula says we could invest as much as 30% of our portfolio in Stock B!
The risk/reward appears attractive enough to place quite a large investment in this case.
One way to stress-test the idea is to consider this thought experiment: If you found an investment idea that had a 100% probability of appreciating 20%, how much would you invest in it?
So In Summary...
- There IS such a thing as too much diversification. A portfolio of around 30 stocks may be able to provide most of the “free lunch” benefits of diversification.
- A concentrated portfolio approach can result in a more efficiently manageable portfolio.
- There are many approaches to portfolio sizing from equal weighting to a probability weighted risk/reward methodology like The Kelly Formula.
Some Additional Thoughts
- A probability-weight approach has its own shortcomings. In addition to estimating a target price, we now need to estimate a downside target as well as probabilities. What if our estimates of gain/loss probabilities are wildly wrong? Unfortunately, the Behavioral Sciences have shown that humans are just not that good at probabilistic thinking.
- Finally, no portfolio sizing note is complete without noting that the discussion gets quite even more complicated when one begins to factor in a client's individual risk tolerance, investment horizon, and need for liquidity.
Finally, for those inclined, here is an adjusted version of The Kelly Formula
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice. A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.