Everyone “knows” you should have a diversified share portfolio. What other kind of portfolio would you want? How many holdings do you need to achieve true diversification?
The short answer: Nearly all of them.
The long answer is a little more nuanced, but comes to basically the same place: all of them, with a little bit of wiggle room. If you’re just looking to reduce your standard deviation (the measure of how volatile a portfolio is), you may only need somewhere between 30 and 50 share holdings to make a noticeable difference. But that’s not diversification.
A truly diversified portfolio represents the stock market as a whole; the real value of diversification is in building your portfolio around the things that actually matter — the systematic risks that give you the extra potential reward.
Academics, by and large, break risk into two categories — systematic and unsystematic. The market should “pay” you for systematic risks that you can’t get rid of, like shares being riskier than cash on deposit. But you don’t get paid for unsystematic risks that you can get rid of, such as a company’s CEO’s past Tweets (or “X”s!). Those types of risk are just noise, and they should cancel out over time. So, we want to keep the systematic risk, and get rid of the unsystematic risk. The best way of doing this is to diversify, as far as possible.
Eliminating unsystematic risk requires bringing in a much larger number of stocks — significantly more than simply smoothing out the day-to-day gyrations. If you only own the 30 to 50 stocks needed to dampen the daily bounces, you’re still exposed to only a very small portion of the market. To give you a sense of perspective, at the end of December last year, there were over 1,500 shares in the MSCI World Index (this index covers the large and mid-size companies in 23 developed markets). Every company is unique in their specifics. They are all going to succeed or fail in their own way, and in aggregate, they make up a large part of the world economy (remember that there are many companies whose shares you cannot buy, and other businesses and organisations which contribute to the global economy). Ideally, to represent that economy, you need to own enough shares to cancel out the specifics.
And shares aren’t the only asset you should hold. The diversification argument applies to the other mainstay of most investment portfolios – fixed interest stock (loans to governments and companies).
It is impractical for private investors to directly own the number of shares and stocks they need for diversification. The best solution is to use funds to buy your shares and stocks. Our approach is to recommend different funds to suit your requirements.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner