Diversification: A Hedge on Poor Decisions?
Why Over-Diversification Can Dilute Returns for the Dedicated Investor
Portfolio allocation and sizing is hot button issue for many investors, you hear the CNBC pundits telling you to “diversify” and everyone telling you “don’t put all your eggs in one basket.” While this advise might be true for the average person, or an investor who is not willing to put in the work. For the aspiring investors, great ideas do not grow on trees, and you should be careful about diluting your portfolio with lower quality companies. What does Buffett think of this? he once said “Diversification is protection against ignorance. It makes very little sense for those who know what they are doing."
When you have good business’s in your portfolio. You should be not only reluctant to sell those good business’s but reluctant to add any new positions. When you purchase a business in the stock market, you are essentially saying you like that company, at that price, better than any other company in the world. Including the ones you are already invested in. Peter Lynch “The best stock to buy, may be the one you already own.” Now I’m not advocating for everyone to have a one stock portfolio, but adding a new position just for the sake of having diversification is a recipe for poor returns. A portfolio of 3-20 quality business’s can be all the “diversification” that an investor needs. Charlie Munger "You're just hurting yourself looking for 50 (stocks) when three will suffice."
Evans and Archer Study (1968) This study suggested that as few as 10 randomly selected stocks could significantly reduce company specific risk, capturing most of the benefits from diversification. Beyond this point, the marginal benefit of adding more stocks diminished rapidly. Most studies also agree that the greatest reduction of “risk” happens within the first few stocks, and a portfolio of 7-10 stocks can provide most of the benefits of a “diversified portfolio.” Continuing to add new positions will continue to “diversify” you and reduce company specific risks but at a much lower rate and you start to run the risk of diluting your portfolio. It’s also important to consider overlapping risks between your holdings. If you own multiple companies within the same industry or for example multiple holdings that are sensitive to interest rates, you might be even more concentrated than you realize.
Nomad Investment Partnership founded in 2001 by Nick Sleep and Qais Zakaria. Nomad was not one of longest lasting partnerships, but it is one of the most successful, and is a perfect example of what we have discussed today. In 2014 when the partnership closed it had a total return of 921.1% over 13 years. Outperforming the S&P 500 by roughly 800% over the same time. A hallmark of their portfolio; A Terminal Portfolio, a large concentration into just three main holdings. The three largest holdings in the portfolio; Amazon, Costco, and Berkshire Hathaway. Companies that aligned with the qualities, and characteristics Nomad was looking for. Nomad believed so deeply in these companies that when they closed down in 2014, they subtly encouraged investors to continue to own Amazon, Costco and Berkshire Hathaway well in to the future. Nomad investors who decided to buy these 3 holdings in 2014, would have a total return of over 700% in 2025, showing no signs of slowing down anytime soon. This 700% return over the last 11 years is over 400% better than the S&P 500’s performance over the same time frame.
The exact number of stocks one should hold in their portfolio is specific to each investor, but for the aspiring investors out their, I hope we are past adding stocks to the portfolio, just for the sake of “diversity”. As for myself, I currently own 6 stocks. A mix of companies from mega cap to micro cap, with little to no overlapping company specific risks. I’ve owned more than 6 stocks, I’ve owned less than 6 stocks, but right now I sleep very well with my portfolio. What are your thoughts on a “diversification”, and how many stocks are in your portfolio?