From the pen of Karin Iten…

Dear Investment Academy Reader,

As trading screens turned red across the world last week, investors might have questioned one of investing’s oldest mantras. Diversification – not putting all your eggs in one basket – which aims to cut risk by spreading it over lots of different investments, so that when one is falling another is rising to compensate.

But when the market melts down, no share portfolio is safe. And even in more stable times investors waste time and money spreading themselves too thin. So how much diversification do you really need? This week, MoneyWeek Online contributor, Tim Bennett explores the question.

The difference between sprinters and plodders

One of the keys to equity diversification is understanding how different types of stock perform in relation to the overall market. Fans of the capital asset pricing model say you can predict most of the time how certain sectors or shares will behave in the future by looking at their past records. Some are cyclical. They are said to have a high beta. When times are good, people want what they offer, but when harder times strike, demand wanes fast. This commercial volatility is reflected in the share price. Highly cyclical sectors include technology, luxury goods and travel.

These contrast with counter cyclical, or defensive, sectors, which generally have a low beta. Take household goods producers such as Reckitt Benkiser. We might hunt for cheaper alternatives in a downturn, but we don’t give up soap, washing powder and toothpaste entirely.
 
The same logic applies to tobacco, alcohol and drug firms. Because these tend to have loyal consumers, cash flows tend to be stable, meaning they can pay decent dividends. Fans of diversification suggest that by owning a portfolio containing a mix of cyclical and counter-cyclical stocks, you can hope to earn decent returns while ironing out the market’s biggest wrinkles.

But what’s the optimum number of stocks?

The magic number...

James Montier at GMO reckons a typical fund manager holds 100 to 160 stocks – which is “madness”. The trading costs of setting up such a large portfolio are huge; and the time needed to manage it could be better spent elsewhere. By holding just two stocks, says Montier, an investor can cut “non-market” risk (stock-specific risk, rather than the risk of a collapse in which all stocks are trashed) by nearly half.

Buy 32 and 96% of that risk is eliminated. So by holding 30-40 shares you’ll get “the vast majority” of any diversification benefits. As Warren Buffett puts it, “wide diversification is only used when investors don’t understand what they are doing”.

Here's what to do

Even building a 30-40 strong portfolio is a hassle for many investors. Broker fees will wipe out a chunk of any gains unless you buy a decent amount of each share.

So many would be better off using cheap exchange-traded funds (ETFs) to track the bits of the market they like, rather than taking an expensive and time-consuming “build your own” approach. Above all, avoid paying an expensive fund manager to buy too many stocks on your behalf.

Here’s to your financial freedom

Tim Bennett
for the Investment Academy