Mainstream thinking requires “adequate” diversification in portfolios. Adequate generally means more than 25 stocks. The aim is risk reduction; to limit the exposure to any one “sector” so that if one stock is down most others likely won’t be, or may be up. If we have a deeper think about this, a number of issues arise.

As an investment manager, why should I have you invest into my 25th or 30th best idea?

For two main reasons; one, I am not certain of the future of any one of my stocks. I’m more certain that as a whole the basket of stocks will do well, and secondly, I don’t want my portfolio to experience large swings in volatility. The bigger the basket, the more likely performance will at least match what the market does. Here the fund manager is admitting they have little conviction in any one of their investment ideas. Granted, the only thing certain is that we can’t be certain of nearly anything and we prefer to hold a number of stocks to cater for that. But holding 25 or more is an admission that you have scarce conviction in your analysis.

Adding more stocks reduces performance and adds risk. If the analysis is quality then investing in the bottom 10 ideas of a 30 stock portfolio is reducing that portfolio’s performance. In our experience, there’s not many great companies to choose from. If we were to rank our best 30 investment ideas in order of risk and expected performance, the bottom 10 would be nowhere near what we expect the top 10 to achieve (those that we expect to grow the fastest with acceptable levels of risk). If we invest in them we are adding risk and reducing performance.

The caveat is quality

Quality analysis leads to high degrees of certainty but it also takes time. If you have 30 stocks in your portfolio you won’t have time to adequately analyse and monitor those companies and their competitors. You are in fact adding risk – not subtracting it. The caveat of course, is that your analysis is quality. Those without the knowledge and time to adequately analyse companies require diversification and are best served by indices.

Implication – Accept volatility

Quality analysis leads to high degrees of certainty but it also takes time. If you have 30 stocks in your portfolio you won’t have time to adequately analyse and monitor those companies and their competitors. You are in fact adding risk – not subtracting it. The caveat of course, is that your analysis is quality. Those without the knowledge and time to adequately analyse companies require diversification and are best served by indices.