Diversification is Overrated
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In the 1950s economist Harry Markowitz developed Modern Portfolio Theory(MPT) for which he won the Nobel Prize in Economics. In the 1960s William Sharpe, building on MPT, developed the Capital Asset Pricing Model (CAPM) and also won a Nobel Prize in Economics sharing it with Markowitz. Among the implications of these economic theories was the concept of diversification to reduce risk.
Most US investors in the 1950s and 1960 typically only had 4-8 stocks in their portfolios. These new economic models proposed that investors need greater diversification to optimize the risk-reward trade-off.
It is from these concepts, that the modern financial industry has evolved in its recommended portfolio solutions. Over the last 20 years, the industry has created ‘all-in-one’ portfolio solutions that blend stocks and bonds according to desired risk tolerance. Within each of these two assets classes, there’s extensive diversification, but how much is enough?
Academically it has been shown that most risk-reduction occurs at between 20 and 30 stocks, and that diversification beyond that quantity adds disproportionately little in terms of risk reduction*.
*(Elton, Edwin & Gruber, Martin & Brown, Stephen & Goetzmann, William. (2007). Modern Portfolio Theory and Investment Analysis / E.J. Elton... [et al.]..)
Yet today, most mutual fund portfolio solutions and ETFs maintain hundreds (some have thousands) of securities in their all-in-one portfolios.
At the end of this newsletter, Warren Buffett’s business partner, Charlie Munger provides his view on this level of diversification.
Berkshire Hathaway’s success is, in part, due to a highly concentrated portfolio of about 20 stocks or so.
We have created a portfolio strategy that incorporates the concept of a ‘concentrated’ portfolio of 20-30 securities, is easy to understand, and has historically demonstrated better returns with less risk than the broad stock market.
Do you understand your portfolio’s composition and level of diversification? Do you understand what you are invested in and why?