By Logan Kane
- Research shows that the typical investor has fewer than 5 stocks in their portfolio. This is not an effective way to diversify.
- Why awareness of mean-variance optimization is better than shooting from the hip with your portfolio, and why owning more positions helps you let winners run.
- Some interesting implications regarding owning your employers’ stock, short selling, and ETF vs stock investing.
Growing up, when the weather was too cold for golf, I would come home from school and watch Jim Cramer on TV. Cramer was a lot of my early education in the stock market, and his crazy sound effects and viewer call-ins appealed to my adolescent brain on winter days in Missouri. One of the first things I learned from Cramer was that you needed at least 5 stocks to be diversified. To the typical investor who owns fewer than 5 stocks, this is an improvement. However, years later, when I dug into the statistics of the stock market, I found that even owning 5-10 stocks causes you to take too much uncompensated risk. Furthermore, due to the nature of the distribution of stock returns, starting with high concentration will force you to make risk management decisions over time that cause headaches. I’ve found from my research that if you choose to invest in individual stocks, you should aim for 20-25 positions, meaning an initial max concentration of 5 percent in any one company. This gets your non-diversifiable risk to the point where if you’re good at picking stocks, you will know that you’re not just getting lucky.
The Problem With Concentrating Risk In Your Best Ideas
A common line from ex-investment bankers and hedge fund managers is that they like to concentrate their portfolio in their best ideas. However, if you look at the statistics of all the professional investors who do this, the group loses on average to more diversified investors. That’s to say nothing of non-professionals who concentrate risk. I found an excellent report from the research team at S&P which should be required reading for anyone picking stocks. Here’s what they had to say.
Concentrating portfolios, in other words, makes it more likely that good managers will look bad, more likely that bad managers will look good, and more likely that asset owners’ decisions will be informed by luck rather than skill.
In fact, there are clear conflicts of interest when highly educated (often clever but not always highly intelligent) fund managers concentrate their holdings. If they get lucky, investor money pours in, and if they don’t, they get another job at another fund somewhere. I’d conservatively say that 90 percent of the alpha in the stock market goes to 10 percent of the participants. If you’re not in the 10 percent, your best bet is to be lucky, which concentrating makes more likely.
The below graph makes this point clear. If you have an edge in the markets, it will show, and the more independent outcomes you have, the better you’re likely to do, luck be damned.
Source: Standard & Poors
Another immediate consequence and the one that you’ll typically see in the literature is that portfolios that are less diversified almost always have higher amounts of risk, as defined by standard deviation.
Source: Standard and Poors
You can compare the dispersion–or volatility of the typical single stock–to the volatility of the S&P 500 index (SPY). This is a historical graph but single stock volatility has been as high as 2000 and 2008 were in 2020. As such, a lack of diversification is a significant risk management problem in bear markets. The obvious corollary is that the fewer stocks you own, the greater the risk you bear.
One other issue is the extreme right tail in the distribution of individual stock returns. The median stock returns less than 5 percent, around a third return negative over the long run, and about 1 in 7 stocks return more than 20 percent annually. This general pattern holds true across different countries and indices. I’ve previously written about this, what researchers refer to as the “capitalism distribution.” What’s interesting about this also is that research shows the proper approach is to let your winners run and cut your losers, which is harder to pull off if you start with a less diversified portfolio.
If you start holdings at 10-20 percent and they grow massively, let’s say you bought Apple (AAPL) when the iPod came out, you start to have a problem. Your best performing stock starts to take over your portfolio. There are a few Seeking Alpha members who have shared their experience of their portfolio becoming almost all Apple over time. The issue is that you’re strapped into a roller coaster of a stock that’s performed great from point A to point B, but you’re utterly dependent on one stock, which in the case of Apple, has dropped 80 percent once in the last 20 years, 50 percent another time, and 30+ percent two more times. For more, I wrote about this in my article titled “Apple and the Disposition Effect.“
What’s the best approach with all of this in mind? If your head is spinning by reading this, the answer is ETFs. With 5-7 ETFs, you can create a set-and-forget portfolio that’s backed by research and tends to outperform your neighbors who pick stocks. If you’re brave enough, you can take the same risk as your neighbors who don’t manage risk well and get extra return on a diversified portfolio via the use of modest amounts of leverage. Do note that since you need to itemize your tax deductions to deduct margin interest, this approach is best for those with a household income of $100,000 or higher, and only if you can borrow for less than a couple of percent per year in interest. What’s more effective is that S&P or NASDAQ E-micro and E-mini futures can offer a solution at a lower price point and a lower implied interest rate, however.
Some Pointers on Portfolio Construction
1. Owning less than 10 stocks exposes you to uncompensated risk. Since investors tend to gravitate to drama and volatility anyway, I would estimate the typical retail investor portfolio has a standard deviation of somewhere between 20-25 percent in a normal year. This is much higher than the 15 percent the S&P averages. By comparison, you could use futures to leverage the S&P 500 at 1.5x, rebalance monthly, and crush the typical investor at the same 20-25 volatility threshold.
2. Mean-variance optimization strongly outperforms random stock selection and closet indexing in reducing risk. There is some fancy software out there for this, but Portfolio Visualizer offers a lot of the same functionality for free. This might mean that owning something like Walmart (WMT) or Kroger (KR) is helpful in a downturn, or if you were savvy enough, buying work from home stocks like DocuSign (DOCU) before the virus shutdowns happened. Mean-variance optimization is not always an exact science, but being aware of industry diversification and correlations in different market environments help you reduce risk.
3. Short selling gets a bad rap but is statistically effective, but with 1/3 of stocks having long-run negative returns and the companies that do so having a lot in common (losing money, high debt loads at expensive interest rates, junk credit ratings), having a few short positions among your 20-25 single stock positions tends to help your portfolio’s risk/return profile. An interesting thought experiment is to consider whether it’s easier to buy the market and short the trash out of it or to short the market and buy the best. Research shows that 63 percent of the alpha is on the short side. The same rules of diversification apply as long-only portfolios, except short selling requires additional attention with regards to risk management. Selling calls on popular stocks that are failing instead of shorting directly also improves the returns from this type of strategy, because Robinhooders have bid up call option implied volatilities to levels that are not found in reality.
4. If you work a corporate job, own as little of your employers’ stock as possible, unless you’re getting stock options. Probability distributions of all the stocks out there indicate a roughly 2 in 3 chance it will underperform the S&P 500, and if you’re VP level or above, your economic fortunes are already somewhat tied to your employers’ success. Don’t do this, even if other people do! Most people don’t make much money in the market.
There are a thousand ways to make a buck in the financial markets, but one of the most popular approaches is one of the least effective. Owning a poorly diversified portfolio has a cost, and the larger the size of your portfolio compared with your income, the greater this cost is. If you want to play around with $5,000, be my guest, but if you have a sizable portfolio, it pays to professionally manage risk. If you’re good at portfolio management, embrace the opportunity to invest money in a higher number of stocks to improve the probability of having one or more long-term 10x winners in your portfolio. Be conservative with your portfolio construction so you have the flexibility to let winners run and cut losses, and the rest will take care of itself. Lastly, ETFs and futures offer the most bang for the buck, allowing for you to focus on leveraging and risk management for the same level of volatility, which is a far more exact science than picking stocks.
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Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.