Diversify!
Newbie investors have been hammered with that bit of advice since man first rubbed two sticks together, as this cartoon clearly documents:
But is there such a thing as too much diversification? Yes, in fact, there absolutely is, according to Phil Fisher, an influential stockpicker whom Warren Buffett BRK.A, +1.14% credits as a major source of inspiration.
“Investors have been so oversold on diversification,” Fisher said many decades ago, “that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.”
Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, agrees, saying that while diversification is critical in mitigating risk, active market participants should be mindful of just how much diversity is ideal.
“Too much of anything can be bad for you and diversification can be taken too far,” he wrote in a post on the Intrinsic Investing blog. “But the level at which ‘too far’ kicks in is surprising to most people.”
That number, of course, depends on what an investor is trying to achieve.
Stannard-Stockton used this chart — based on data discussed in the book, “A Random Walk Down Wall Street,” by Burton Malkiel — to illustrate the ideal number of stocks to own for those looking to beat the market:
As you can see, once 25 stocks are owned, active investors pretty much capture all the benefits of diversification. That’s assuming the stocks in the portfolio are selected randomly. Obviously, 25 tech stocks isn’t going to cut it.
“For active investors there is a huge cost to adding new names to a portfolio,” Stannard-Stockton explained. “And there is a huge advantage to be gained by prudently limiting your portfolio to the companies that you ‘thoroughly know.’”
He said what active investors should really avoid is something in the middle of the range between 25 stocks and complete diversification, which would be owning the entire S&P 500 SPX, +0.88% universe.
“Owning 150 stocks or 350 stocks dramatically dilutes any ability you might have to beat the market,” he said, “without adding much in the way of diversification because you already captured most of the benefits with your first 25 stocks.”