With this year’s rough run, you don’t need to remember that stocks are volatile. Their prices bounce up and down, sometimes in extreme ways. The US market as a whole has produced average annual returns of around 10% over the past century, but it’s not growing by 10% every year. In about one year in four, it goes down – sometimes a lot.
If stocks returned the same amount each year, then, like bonds, they would only return a few percentage points. High returns are the reward you get for enduring the fear (often sheer terror) of seeing bits of your nest egg disappear into thin air.
People like me tell you to hold on. History shows that markets rebound. But enduring sickening declines is not easy.
The best way to make driving easier is to diversify. I’m not talking about portfolio diversification here — the allocation of your assets to stocks, bonds, cash, and maybe more. Portfolio diversification is a necessity but a topic for another day. Today’s topic is diversification into the part of your portfolio that consists of stocks and stock funds.
The value of diversification seems awfully obvious. Morningstar data in June 2021 showed that around 39% of all US stocks had already suffered three-month losses of 50% or more, but less than 1% of diversified equity funds had suffered such severe losses. .
Consider the sad history of Enron, once a high-flying Houston energy company. When it collapsed in 2001, thousands of investors, including Enron employees whose retirement plans were heavily invested in the stock, suffered huge losses. Enron was the seventh largest company in the Fortune 500, but in 2000 its market capitalization (price multiplied by outstanding shares) was less than 1% of the value of the S&P 500 index. If you had invested $10,000 in an S&P 500 index fund and all other stocks held their prices, Enron’s journey to zero would have cost you only $100.
Enron’s earnings per share had fallen from 9 cents in 1989 to $1.47 in 2000, rising almost every year. But the company cooked its books. “Could the average investor have seen through [Enron’s] story and determined that the company was in trouble? Absolutely not,” I wrote 20 years ago. The smartest analysts missed it. The only protection was to diversify.
How much stock diversification is enough?
How much diversification do you need? Certainly, owning an S&P 500 fund such as the Loyalty index 500 (FXAIX), which owns around 500 different companies and is weighted by market capitalization, will do the trick. Or, for super-diversification, there is the Vanguard Total Stock Market (VTI), an exchange-traded fund that owns 4,119 separate stocks. (Funds and stocks I like are in bold; prices and other data are as of May 6, unless otherwise noted.)
But what if you want to build your own portfolio of individual stocks? A debate rages among economists about how many stocks you need to reap the benefits of diversification. Specifically, it is a discussion of how much adding additional stocks reduces your overall risk.
In a 1968 journal article, two University of Washington researchers, John Evans and Stephen Archer, stated that the minimum stock portfolio size should be 10. Another study conducted around the same time showed that the standard deviation, a popular measure of volatility, was 49.2% with a single-stock portfolio and 23.9% with 10. But after that, according to the study, the risk slowly declines – 20.2% with a portfolio of 50 stocks, for example.
In 1987, finance professor Meir Statman disagreed. In a highly cited paper that used a different method of analysis, he concluded that investors needed “at least 30 stocks.” Another group of economists, led by John Campbell of Harvard, determined that 50 were needed.
In all of these cases, however, the stock count is only part of a diversification strategy. You also need to diversify by sector. If your 30 stocks were in energy, for example, your average annual return over the past 10 years would have been 5.6% (the performance of the S&P Energy Sector Index), compared to 13.9% annualized for the S&P 500. as a whole.
You should also keep your portfolio as close to the same weighting as possible. You are not diversified if you hold 30 stocks, with 29 each representing 1% of total assets and one representing 71%. The best way to stay balanced is to reallocate your holdings at the end of each year or semester. Sell stocks that have risen sharply in value and use the proceeds to buy more stocks from laggards. Be aware that by selling profitable stocks you will incur taxes, so try to use offsetting losses or limit your reallocation to a tax-deferred account, such as an IRA.
The way I solve the portfolio size conundrum is to hold eight or nine individual stocks as well as diversified funds, like the SPDR Dow Jones Industrial Average (DIA), an exchange-traded fund dubbed Diamonds, which owns all 30 Dow Jones stocks. The asset values in the stocks and funds in my portfolio are roughly equal. If I only owned the stocks, I wouldn’t get enough diversification protection.
Do you need international stocks or stocks of small companies as well as large caps to achieve true diversification? I do not think so. Of course, invest in European mid-cap stocks, for example, if you think such a sector is undervalued, but if the goal is to achieve market-level returns (or perhaps a little higher) while removing risk, the best strategy is to stick with US Large Caps.
The downside of stock diversification
But diversification also has costs. It dilutes strong convictions. Andrew Carnegie, who in his day was the richest man in the world, disdained diversification. He said in 1885: “The cares that fail are those that have scattered their capital, which means that they have also scattered their brains. ‘Don’t put all your eggs in one basket’ is completely wrong. all your eggs in one basket, then watch that basket.'”
Warren Buffett, the CEO of holding company Berkshire Hathaway (BRK.B), agrees. He says diversification “makes little sense if you know what you’re doing.” Berkshire Hathaway’s stock portfolio at the end of 2021 held 40 listed stocks, but 41% of those assets were in a single stock – Apple (AAPL) – and another 25% were represented by Bank of America (BAC), American Express (AXP) and Chevrons (CVX). “I would say for anybody…who really knows the businesses they’ve gotten into, six [stocks] that’s a lot,” says Buffett, adding that “very few people have become rich on their seventh best idea.”
However, most investors don’t have the time or inclination to “really get to know” these companies. Instead, they save for a more comfortable life, a retirement or the security of their children, not to make a fortune. These investors are content – or should be content – with an average annual return of 10%, which will quadruple their investment in about 15 years.
In addition to owning broad index funds, you can achieve high diversification through low-cost managed funds. Stock Dodge & Cox (DODGX), for example, has an expense ratio of 0.51% and an average annual return of 14.0% over the past 10 years. DODGX – a member of the Kip 25, our favorite low-fee mutual funds – has a portfolio of 74 stocks, the top 10 holdings representing only 32% of total assets, and a good allocation by sector. The turnover is only 10% per year. The fund has held some stocks, including Wells Fargo (WFC) and FedEx (FDX), for more than 30 years.
Owning a single fund with an excellent track record like the Dodge & Cox fund – or Loyalty counter-funds (FCNTX), which has a much bigger wallet but is heavier, or even the Principal investor in Parnassus shares (PRBLX), with only 40 stocks but a wide mix of sectors – is really all you need to achieve solid diversification.
James K. Glassman chairs Glassman Advisory, a public affairs consulting firm. He does not write about his clients. His most recent book is Safety net: the strategy to reduce the risks of your investments in turbulent times. It owns SPDR Dow Jones Industrial Avg. ETFs. You can reach him at [email protected]