Before the global financial crisis (GFC) gripped our world of portfolio construction, I was happy to think in terms of a highly concentrated portfolio of eight to 15 blue-chip stocks. My basis were simple; it’s easier to find a few good stocks than a large number, and the diversification benefits fall off rapidly when increasing the number of stocks. I based my conclusions on my 2005 simulation experiment of historical stock returns.
Adjusting for the recovery
During the 2008 market meltdown, I was asked if I had changed my rule. I didn’t have the time during the GFC to do a proper analysis, so I had arbitrarily increased my range to 15 to 20 stocks. Even with supposedly quality stocks, some companies looked more likely to fall over – or at least take a massive hit in price – during a major bear market, but knowing which ones was tricky. With 15 to 20 stocks, there is less ‘single stock dependence’ on any one stock should it get suspended – or worse!
Now that we have bounced off pre-GFC levels of volatility (although we have experienced some major volatility clusters since) it’s time to revisit the ‘How many stocks should I have in my portfolio?’ question using my previous analytical framework.
Determining volatility
So let’s work out the ideal number of stocks to hold by determining how the number relates to volatility.
I took daily price returns data from the ASX 200 stocks for the two financial years 2008/9 and 2009/10 and simulated the volatility of the two portfolios, hypothetically weighted equally. Of course, using the stocks from the beginning of those financial years doesn’t allow for those that exited the index during those turbulent times.
I constructed one million (yes, you read that right!) randomly drawn equally-weighted portfolios for each size of one through to fifty stocks and then calculated the historic volatility separately for the two financial years. In the chart, you can see the volatility of the median-volatility portfolio for the two years (the blue and the yellow lines) as well as the worst performing portfolio for 2009/10 (the red line). The black dashed line provides a visual guide for the median volatility of a one-stock portfolio (an average single stock).
Chart: Diversification benefits of increasing the number of stocks in a portfolio
The winning number
Unsurprisingly, the volatility of the median portfolio in 2008/9 is much higher than for 2009/10, no matter how many stocks there are in the portfolio. Indeed, I can see that a worst-case portfolio (allowing for the volatilities and correlations of the component stocks) of five-stock portfolios in 2009/10 has about the same volatility as an average portfolio of the same size in the previous year.
By following the black dotted line to the right from the one-stock average portfolio in 2009/10, I can see that it crosses the red line (the worst performing portfolio) at about eight stocks. This was my basis (in 2005) for choosing a minimum of eight stocks in a portfolio – somewhat arbitrary – but my minimum requirement is that I want my portfolio to have no more volatility than an average stock.
The blue line (the 2009/10 median) flattens out quickly by about 15 stocks. In a chart not shown here, a similar analysis on the 2008/9 data produces a minimum number of stocks of 13. The old rules-of-thumb appear to be back on track!
Care must be taken when interpreting these results; the thrust of the analysis is about an average portfolio. It is easy to construct ‘bad’ portfolios by biasing the stock selection to small stocks in a single sector.
How to use this information
So what are the rules? The number of stocks you hold in your portfolio should match your risk profile, but a few simple rules-of-thumb flow from my analysis – and a modicum of common sense:
- Eight (equally-weighted) stocks seems a reasonable minimum in ‘good times’ and this should be increased in bad times – say to 13 or 15 – providing the stocks are chosen without putting too much emphasis on a sector or Small Caps.
- No matter what your choice set is, there is little to gain in a volatility sense by holding many more than 20 to 25 stocks from the ASX 200.
- Using unequal weights has advantages when the weighting is in tune with volatility and correlation.
- Having regard to sector weights helps when those sector returns are less correlated than the returns within a sector.
- The ‘old rules’ seem to still be working and didn’t need too much modification during the GFC.
- Good portfolio construction isn’t for amateurs.
Ron Bewley is the executive director of Woodhall Investment Research [1].
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
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- Charlie Aitken: Strong gains, plus three stock buys [3]
- Andrew Bloore: Should I move my shares into my SMSF now? [4]