Financial planning,  Investing

Too much of a good thing?

Last week I wrote about how important it is to diversify your portfolio, but you can get too much of a good thing. You can reach the point where you’ve got so many different moving parts to your portfolio that it becomes inefficient.

We had a new client come to us a few years ago with a portfolio chock full of 62 different Australian stocks he’d inherited years before from his father. He’d never sold a share, which in some cases has its merits, but the portfolio was way out of whack.

He had a number of shares that had doubled in value, but in each case they’d gone from something like 0.5% of his portfolio to 1%. Whoopy do. And almost all of them were offset by the ones that had halved in value.

Then he had about 18% of his portfolio exposed to BHP and around 20% to the big banks. So five stocks accounted for almost 40% of the portfolio leaving 57 jostling for space in the 60% balance. You can see how he ended up with a whole lot of tiny positions that were all but meaningless to the performance of his portfolio.

One reason for holding a bigger number of stock positions is to reduce ‘stock-specific risk’, that is, to minimise the damage a single holding can do if it goes pear-shaped. However research shows that 93% of stock specific risk can be eliminated by holding just 20 stocks.

Part of the reason for building your own share portfolio is to only own those shares that you’re convinced are going to do well. If you’re not convinced, then don’t own it, and if you don’t know how to be convinced, then maybe you should think about getting some help.

Our client came to see us after BHP had dropped by more than 50% in the two years to the beginning of 2016. Over the same period his bank shares had fallen an average of 15%, so 40% of his portfolio had gone down by 12% in those two years. Just to break even the rest of it would have had to have gone up by 19%. Not surprisingly, they didn’t.

But while he held too many Australian stocks, he didn’t own any international shares or assets that aren’t correlated to share markets. So he was over-diversified at the same time as being under-diversified.

Alternatively you might own some managed funds. A popular strategy, especially among financial planners, is to own a ‘value’ manager as well as a ‘growth’ manager, that way you should have at least part of your portfolio firing regardless of what’s driving the market.

The problem with that strategy is what you can sometimes end up with is a makeshift index fund, which you could get from an ETF for fees of maybe 0.25%, but instead you’ll be paying more like 1% for an active manager.

You may well ask, isn’t owning an index fund too diversified? Not at all. Over the last 20 years Australian shares have returned about 9% per year if you include franking, which is a great return. Global shares have returned 5% over the same period, which isn’t as impressive, but bear in mind they’ve averaged 19% over the past five years, which is awesome!

My point is if you’re going to build your own share portfolio you should avoid having so many holdings that they can’t make a meaningful contribution to its performance, otherwise you may as well own an index fund and save yourself the headache of trying to choose the right stocks. Likewise, if you own a bunch of managed funds but on a combined basis they turn out to be an index fund, then save yourself the money and buy an ETF.

 

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

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