More Eggs in Basket May Crack Portfolio

December 2, 2009 at 2:00 am 1 comment

NOT putting all your eggs in one basket makes intuitive sense to many investors. Burton Malkiel, Princeton Professor, economist, and author, summed it up succinctly, “Diversity reduces adversity.” Diversification acts like shock absorbers on a car – it smoothens out the ride on a bumpy financial road (read more on diversification). Jason Zweig, Wall Street Journal writer, acknowledges the academic findings that underpin these diversification benefits by stating the following:

“As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time.”

 

Despite the evidence, Jason Zweig explores the conventional views on diversification more closely. 

Turning the Diversification Concept on its Head

Zweig, not satisfied with the standard thinking on the topic, decided to explore the work of Don Chance, a finance professor at the Louisiana State University business school. Professor Chance asked more than 200 students to consecutively select stocks until they each held a portfolio of 30 positions. Here are two of the main findings:

1)      Averages Hold Firm: On average, for the group of students, diversifying from a single stock to 20 reduced portfolio risk by roughly 40% – just as would be expected from the academic research.

2)      Individual Portfolios Riskier: After the first few initial stock picks, for each individual portfolio, were made from a list of large cap household names (e.g., XOM, SBUX, NKE), Professor Chance found in many instances students dramatically increased portfolio risk. These students juiced up the octane in their portfolios by venturing into much smaller, more volatile stock selections.

Deceiving Diversification

Gur Huberman, a Columbia Finance Professor also points out a tendency for investors to clump stock selections together in groups with similar risk profiles, thereby reducing diversification benefits. Diversifying from one banking stock to 20 banking stocks may actually do more damage. Statistically, Zweig points out, “Thirteen percent of the time, a 20-stock portfolio generated by computer will be riskier than a one-stock portfolio.”

Professor Chance found similar results according to Zweig:

“One in nine times, they [students] ended up with 30-stock portfolios that were riskier than the single company they had started with. For 23%, the final 30-stock basket fluctuated more than it had with only five stocks.”

 

Diversified Views on Diversification

Chance and Huberman are not the only professionals to question the benefits of diversification:

Warren Buffett: A diversification skeptic declares, “Put all your eggs in one basket and then watch that basket very carefully.” Alternatively, Buffett says, “Diversification is protection against ignorance.”

Peter Lynch: He referred to diversification as “deworsification,” especially when it came to companies diversifying into non-core businesses.

Charlie Munger: “Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

Zweig’s Solution:  

“If you want to pick stocks directly, put 90% to 95% of your money in a total stock-market index fund. Put the rest in three to five stocks, at most, that you can follow closely and hold patiently. Beyond a handful, more companies may well leave you less diversified.”

 

Portfolio diversification and concentration have been issues studied for decades. As you can see, there are different viewpoints regarding the benefits. As Zweig establishes, through the research of Don Chance, putting more eggs in your basket may actually crack your portfolio, not protect it.

Read Complete WSJ Jason Zweig Article

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct positions in XOM, SBUX, BRKA/B or NKE. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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