Diversification is best taken in moderation

By David McEwen

Monday 14th January 2002

My fellow columnist Mary Holm recently took a hard look at an investment rule quoted in my previous article; "resist the allure of diversification".

She came up with some good reasons why investors should not take that rule to heart.

Like her, I do not believe that diversification - the spreading of a portfolio over a variety of investments or asset classes - is a bad thing. However, I do believe many investors overdo it and suffer poor returns as a result.

There are several different kinds of diversification including geographical (investing in different places), asset classes (spreading money between cash, equities, bonds and property), and sectors (different assets within each class).

Let's take equities as an example and look at two mythical investors, Chris Confident and Col Cautious, each of whom has $10,000 to invest.

Both decide to buy a share, SuperBull Unlimited, which they expect will rise by 50% over the next year.

Chris jumps in boots and all and buys $10,000 worth of that company, becoming completely undiversified.

Col, on the other hand, is more prudent and spends only 10% of the portfolio on that share, spreading the rest over several other shares. Now let's assume all other shares rise by 10% during the year and that SuperBull performs as expected. Chris would see a 50% return on a $10,000 investment to end up with $15,000. Meanwhile, Col's return from Superbull would be a comparatively modest $500 on the initial $1,000 investment.

That plus $900 in profits from the other shares would result in a portfolio worth $11,600.

If Col had diversified even further and bought 50 shares, the return from SuperBull's fantastic performance would be only $100 on a $200 investment and a portfolio worth $11,080.

But what if SuperBull had fallen by 50%?

Chris's portfolio would then shrink to $5,000 while Col's 10 share portfolio would still be worth $10,400. A 50-share portfolio would be worth even more at $10,880.

These examples show both the risks and benefits of diversification. Low diversity can mean good returns but also big losses while high diversity means modest results in both directions.

It also shows up that there are two types of risk with shares - systemic (something that affects all shares, such as interest rates changes and the resulting impact on corporate profits) and asystemic (which only affects an individual company).

Systemic risk cannot be avoided by buying more shares, although diversity across asset classes helps. However, more shares will reduce the impact of a problem occurring in an individual company.

So what is the optimum level of diversification? That depends on how confident you feel about your ability to pick winners and how much potential loss you are prepared to take.

Studies in the US market over many years have tended to produce a number within a range of 8 - 20 shares, although a 1993 study (Newbould and Poon) concluded "it may be desirable to have substantially more than 20 stocks in a portfolio to eliminate diversifiable risk."

It is worth keeping in mind that the NZSE40 index has 40 shares, some of which are better performers than others.

One can argue that to beat the index, an investor should hold only the best performing shares. That points to a portfolio of considerably fewer than 40.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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