SIMON BROWN: Don’t overdiversify

Diversification is having many stocks in a portfolio to protect an investor if one of the stocks goes bust. It’s often called the only free lunch in investing, but it can go too far, leaving the investor worse off.

I was recently shown a portfolio that had about 70 JSE-listed stocks, each at less than 2% of the portfolio. The portfolio owner said having many stocks was the only way they felt comfortable.

Fair enough. But there really is an easier way: simply buy a diverse exchange traded fund (ETF) and you get instant diversification on the cheap.

The problem with 70 stocks, or even just 30 or 40, is though it might protect you, it also hinders any real growth. A stock doubling in a large portfolio won’t be noticed, just as one going to zero won’t be really noticed either (from a performance point of view).

A concentrated portfolio of about a dozen stocks is needed to get proper outperformance from your holdings. But that level of concentration is also risky. With 12 stocks, and each of them about 8% of your portfolio, if you held Steinhoff you’d have taken a nasty hit. But on the downside your loss is capped at 100%, whereas winners are uncapped. So a Steinhoff would hurt, but it would be more than offset by a 10-bagger that goes up 1,000%.

My 12 or so stocks sit at the top of my investment pyramid. At the base the majority of my portfolio is held in ETFs, making up more than 50% of the portfolio. These ETFs are mostly diverse global ETFs with some tactical ETFs giving me specific sector or geographic exposure.

And I then watch those 12 or so stocks like a hawk. I know them well, I know what drives their profits and in my true long-term portfolio I seldom sell.

Along the way there will be some distressing drawdowns. For example Shoprite* which I first bought about 20 years ago at around 800c traded at close to R240 in 2018 before hitting R100 during the pandemic sell-off. It wasn’t fun, but I wasn’t tempted to sell. My mistake was that I also wasn’t tempted to buy more at that price.

If you have an overly diverse portfolio, consider trimming it. Your extremely small positions should either be bulked up or exited. The dogs, those stock with no real hope, should be exited. And as for losers that you’re only holding because you don’t want to take the loss — sell them. Sure, selling makes the loss real, but it’s no less real just because you haven’t sold. Ask yourself if there is somewhere better for your hard-earned money to be invested. The answer is nearly always yes.

As a last point, owning five gold miners is also not diversified. That’s just being a gold bull without conviction. True diversification needs to be across sectors and ideally even geographies.

*The writer holds shares in Shoprite