In my last column, I outlined how many stocks you should own in your SMSF portfolio [1]. As we discovered, eight to 15 stocks seems a reasonable number to hold to receive diversification benefits during normal times. In more volatile times, we found that perhaps 13 to 25 is a more relevant range. The increase in the number of stocks in part allows for the increased chance of one or more stocks really tanking in particularly volatile times.
I was a guest on SWITZER on Sky Business recently (you can watch me here [2]) and I argued that we are now enjoying pre-GFC levels of market volatility. While eight to 15 stocks per portfolio might be the current way to go, an eye should always be kept on volatility levels to check whether there would be benefits from further diversification in the event of a renewed bout of disturbances – particularly from Europe.
This week I’ll demonstrate how the market capitalisation on stocks in the ASX200 can impact returns.
Let’s take a look at what happens to returns if the set of stocks is restricted to just the ASX50, the ASX100, or the mid-caps (stocks 51-100 in the ASX100). Clearly, there is no overlap between the ASX50 and mid-caps.
Using the same methodology as in my last column, I’ve shown the median volatility of randomly produced, equally-weighted portfolios in the Chart for 2008/9, which was the height of the GFC. The comparable chart for 2009/10 (not shown) looks similar except all volatilities are much, much lower.
Chart: Median volatility benefits of focusing on blue-chip stocks in 2008/9
Nothing beats the top 50
The chart shows that each curve has the same characteristic drop-off in volatility as more stocks are added to the equally-weighted portfolios. The ASX50 curve – which is basically top 50 ASX-listed companies ranked by the total value of their shares, and are predominately blue-chip companies – is below the ASX100 everywhere – but more so in a relative sense for a larger portfolio. The difference between mid-caps and the ASX200 is very small. That is, the random selection of stocks for these equally-weighted portfolios falls off rapidly when the selection happens to include stocks outside the top 50.
For instance, the median volatility of a seven-stock (or more) portfolio selected only from the ASX50 is lower than the median of any sized portfolio from the ASX200. As you can see, adding more small-cap stocks does little to reduce portfolio volatility.
This confirms what I have argued in previous columns: size matters when choosing the universe of stocks to follow [3].
While it may seem boring to just own stocks with household names from the top 50, the cost in terms of risk of delving into the small cap space is immense – even in a 13 to 25 stock portfolio. Before buying a small-cap stock – even within the top 200 – you should be convinced that its expected gains are so high that the extra risk is worth it.
In the next few columns, I will further develop the number-of-stock question by considering the impact of including a ‘core’ of the ASX200 index in a so-called core-satellite portfolio. This type of strategy gives the investor a little more wiggle room in choosing one or two small-cap stocks!
Ron Bewley, Executive Director of Woodhall Investment Research [4].
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.
Also in the Switzer Super Report
- Peter Switzer: This will be an OK year for long-term investors [5]
- Charlie Aitken: There’s little growth in top 10 stocks this year [6]
- Andrew Bloore: Avoid the CGT death trap [7]