In yesterday's post, we discussed some of the drawbacks caused by portfolio size. As "mass-managed money" pools grow larger, they are forced to own more and more portfolio holdings and those holdings typically need to be in larger and larger companies as well.
Some of the largest mutual funds have well over two hundred names -- one fund mentioned as an example had 286. A common question you might have is, "But doesn't that at least give you diversification?"
Diversification is an important concept in investment management. However, the marketing machine of Wall Street has taken an important investment concept and used it, in some cases, to convince people that they need to own more different products, and therby more holdings, than they actually need.
As the graph above illustrates, diversification does reduce the volatility of a portfolio. However, the reduction in volatility is great when you take a one-stock portfolio and make it a two-stock portfolio. There is another large reduction in volatility when you make the two-stock portfolio a three-stock portfolio, but the reduction is slightly less than it was when you went from a one-stock portfolio to a two-stock portfolio. Each additional stock reduces volatility a little less than the last one did. After ten stocks, the reduction in volatility begins to slow dramatically with each additional holding, and after twenty-five stocks the reduction in volatility is very slight, becoming asymptotic after thirty or so holdings. This property of portfolio volatility is well-researched and has been published in many different places for over forty years.
In other words, mass-managed portfolios do not own 286 stocks for diversification purposes. The reason most investors (even wealthy investors) do not know about this principle is probably because there is a vested interest in the investment industry in having people buy numerous products. If people realized that the capital they allocate to the financial markets could be properly invested in a relatively small number of individual stocks and bonds (likely no more than fifty companies), it would seriously threaten the business models of those who make a living selling investors slices of everything under the sun (each slice containing hundreds of individual stocks or bonds, in some cases).
There are many costs associated with owning many more investment vehicles than you need. There are obviously transaction costs and management costs involved, but just as important are the potential opportunity costs. It is true that some businesses are better than others. The more companies you buy, the more chance you have of buying into average or below-average companies. This problem could be called "de-worsification" and it is a serious problem for many investors (although not necessarily a problem at all for Wall Street).
For later blog posts dealing with this same subject, see also:
- "Build your house of bricks" 02/25/2008.
- "Some drawbacks of mutual funds" 05/20/2008.
- "Invest like Mr. Howell" 05/18/2009.
- "A conversation with Gerry Frigon" 08/10/2009.
- "The hard-money real-estate sinkhole" 09/17/2009.
- "The dance of the hippos" 08/10/2010.
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