In volatile markets, investors may be tempted to take a chance, trying to pick a handful of stocks they believe will benefit from any rally, while avoiding those that look set to lose.
But failing to diversify adequately can make your portfolio less likely to hold the small portion of stocks that drive long-term market performance and lead to poor performance.
Portfolio diversification is easy to understand. At one end of the spectrum, you may have a concentrated portfolio of just one stock, or perhaps a handful. At the other end, you may have a broadly diversified portfolio that may consist of hundreds or even thousands of securities.
Diversifying investment portfolios is conventional wisdom for two fundamental reasons: risk and return.
The risk aspect is quite simple. All other things being equal, risk-averse investors don’t like to see the value of their investments fluctuate wildly.
By holding a variety of assets, which are not perfectly correlated to each other, investors can protect their portfolios from unwanted volatility. The lower the correlation between asset classes, the greater the benefits of diversification. This is one of the reasons why, over the past 20 years, portfolios comprised of stocks and bonds have generated strong risk-adjusted returns, as stock and bond returns have tended to move in opposite directions.
Diversification within asset classes also makes sense from a risk mitigation perspective. It reduces the impact that large drops in a stock will have on the portfolio.
What is less well understood are the implications of diversification for investment returns.
Take the example of stocks. Empirically, the returns of a broad stock index, such as the US S&P 500, are determined by the high returns of a relatively small number of stocks. In recent years, that has meant tech stocks like Apple and Nvidia.
Some investors might think that concentrated portfolios made up of their “best ideas” would be the surest route to outperforming stock markets. The premise here is that when a portfolio consists of only a manager’s best picks, returns are not diluted by second-best ideas or less.
But the reality is different. Our research shows that concentration reduces the chances of owning the few stocks that generate returns. That’s partly because it’s hard to pull off investment calls year after year. It’s also because if investors get it wrong, it’s much harder to recoup those losses and start earning positive cumulative returns.
In other words, the high level of volatility associated with owning a handful of stocks results in slower performance, compared to a portfolio of more stocks.
For example, imagine two wallets, each with an initial value of £100. Portfolio 1, a low volatility portfolio, achieves a return of 5% in the first year, followed by a return of -5% in the second year. Portfolio 2, a high volatility portfolio, achieves returns of 40% followed by -40%. Both portfolios have a return of zero, taking an average of the results of the two years.
But what matters to investors is the compounded return. While Wallet 1 has largely recouped its losses by the end of year two, reaching a value of £99.75, Wallet 2 will be worth just £84. This impact of higher volatility on portfolio returns is often referred to as the “volatility downturn”.
A simulation exercise that randomly selects stocks to create portfolios of different sizes shows that some portfolios outperform the benchmark while others underperform. However, concentrated portfolios are more exposed to slowing volatility.
For example, based on our research, in randomly selected portfolios with five stocks, the average excess return (relative to the Russell 3000 Index) of outperforming portfolios is 2.4%; but for underperforming portfolios, the average loss is larger, at 3.8%. The impact of this volatility decreases as the number of stocks in the portfolio increases.
What is sufficient diversification? Portfolios of 10 or even 20 holdings are, in our view, too concentrated to give investors a decent chance of success. It is only when a portfolio reaches 50 to 100 stocks that the odds shift significantly in favor of returns.
Concentration can be bad for investors. This reduces the chances of owning the few stocks that generate returns; it also increases the chances of ending up with a highly volatile portfolio which could ultimately lead to poor performance. Diversification, on the other hand, is conventional wisdom for good reason: it is an essential tool for reducing portfolio risk and it reduces the exposure of portfolio returns to volatility.
Giulio Renzi-Ricci is Head of Asset Allocation at Vanguard Europe. This article was co-authored with Jumana Saleheen, Chief Economist and Head of the Investment Strategy Group at Vanguard Europe.