In my previous two columns, I demonstrated that there is a simple pair of rules that govern how many stocks should be in your portfolio. These are:
- When market volatility is normal, about eight to 15 stocks might suffice to reduce portfolio volatility through diversification without needing to find too many potentially good stocks (read How many stocks should be in your SMSF portfolio? [1]).
- There are great potential gains in volatility to be had by selecting stocks from just the top 50 blue chip companies (read How market caps affect your portfolio’s performance [2]).
The first ‘rule’ is adjusted for more volatile times by increasing the minimum number of stocks to between 13 and 15 with a maximum of, say, 25 stocks.
Using ETFs in your portfolio
Investors who are new to portfolio construction might find it hard to find sufficient good stocks to get going. With the increase of interest in exchange-traded funds (ETFs) some investors are opting out of stock selection altogether by looking towards investing in the index rather than individual stocks. But what about a compromise? Say, a few stocks and an ETF? There are a number of ETFs designed to mimic the ASX200.
So, to reflect an ETF in a portfolio, let’s revisit the ‘number of stocks’ question, but this time, let’s assume one of those stocks is forced to be the ASX200 index – and not necessarily equally weighted with the stocks.
I used data from 2010/11 this time to construct simulations of a number of equally-weighted portfolios of randomly chosen top-200 stocks, plus ‘core’ holdings in the ASX200 ranging in size between 0% and 80% of the total portfolio and measured in 20 percentage-point increments. For example, a portfolio with an 80% ‘core’ plus five stocks has 80% invested in the ASX200 and the additional five stocks each get 4% of the total portfolio value – making 100% in total.
Rather than just estimating the average volatility of each of these hypothetical portfolios, I computed the median volatility and the 99th percentile, which is the maximum volatility of the one million simulations after eliminating the worst 1% of portfolios in terms of volatility. I summarise the key results in the chart below.
Chart: Volatility and number of stocks
Understanding the chart
The solid purple line (0% core) represents the 99th percentile of the portfolios – an almost worst-case random choice of stocks – with no index, or core, included. The dotted purple line represents the median volatilities from the same 0%-core portfolios. This median result is directly comparable to those I presented in my previous columns, the only difference being the year from which the data have been taken. Both purple lines flatten out by the time 10 stocks have been included in the portfolio – in line with the eight to 15-stock rule.
In the chart, the yellow line represents the 99th percentile of portfolios that includes 20% invested in the ASX200 index. As you can see, in the one-stock portfolio along the yellow line, there is 20% invested in the index and 80% in the single stock, and accordingly, volatility is high. In the two-stock portfolio along the same line, there is 20% invested in the index and 40% in each of the two stocks, etc.
Core size
There is no dramatic improvement by including a 20% core in your portfolio. However, as the size of the core increases, important gains are made. For a 40% core (represented by the green line), the 99th percentile ‘worst-case’ gets close to the average portfolio with no core by the time five or six stocks accompany the 40% core.
When the core is 60%, the red line for the 99th percentile is lower than the median 0%-core line for two or more stocks. An 80% core brings the 99th percentile below the median 0% core for all numbers of stocks. In other words, an almost worst-case scenario for an 80%-core is better than an average 0%-core portfolio with any number of stocks.
The bottom line
The conclusions are straightforward. An investor who can tolerate the typical volatility of an equity market need only find two or three stocks to combine with a core of 60% or 80% in the index. While this combination reduces volatility over 0%-core strategies, it does make it harder to get much outperformance or ‘alpha’. But then again, investors new to equity markets should perhaps start slowly. Next time, I will combine the results of my entire series on ‘How many stocks to own’ to suggest a strategy for an SMSF share portfolio.
Ron Bewley, Executive Director, Woodhall Investment Research.
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: There’s a blue sky behind those dark clouds [3]
- Charlie Aitken: I’m very bullish on this Australian company [4]
- Andrew Bloore: Should I take out insurance using my SMSF? [5]