The Risks Of (Over-)Diversification

While many mutual fund managers have hundreds of stocks in their portfolios as a way to diversify away stock specific risk, James K. Glassman says you can get nearly the same diversification benefit with many, many fewer holdings.

“One reason fund managers own a lot of stocks is that diversification dampens risk, which I define here as volatility—how much an investment’s returns swing from day to day, month to month and year to year,” Glassman writes in his Kiplinger column. “But you don’t really have to own hundreds of stocks to reduce volatility. For instance, Edwin Elton and his colleagues conclude in their textbook, Modern Portfolio Theory and Investment Analysis, that if you own 1,000 stocks, your portfolio will be 61% less volatile than if you own just one stock. But if you own 20 stocks, your risk falls 59%, or nearly as much as it declines with 1,000 stocks.”

One advocate of a concentrated portfolio, Glassman notes: Warren Buffett. In the 1993 annual report of Berkshire Hathaway, Buffett wrote, “If you are … able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices.… In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.'”

But, Glassman says, concentrated portfolios don’t always beat the market. In fact, he notes that, according to Morningstar the 398 U.S. stock funds with fewer than 40 holdings have returned an average of 15.4% annualized over the past five years, lagging the 16.2% for all 2,426 U.S. stock funds. So, he looks at a handful of focused funds that he likes. Among them: Donald Yacktman’s AMG Yacktman Focused and Chuck Akre’s Akre Focus.

“The case for fewer stocks is overwhelming, both for the mutual funds you buy and the portfolios you create yourself,” Glassman concludes. “But there’s a catch. You have to be an active investor, with an eye for great managers, and you have to be comfortable with volatility, committed for the long haul and willing to ride out the inevitable ups and downs. That’s only fair.”