Most investors recognise that holding a diversified portfolio of high-quality assets is a key risk management technique. In today’s article, I want to explore the idea of portfolio diversification as a risk management technique in more detaill – in particular, looking at the pros and cons of diversified portfolio vs. a concentrated portfolio, and how I manage my own. The basic principle being diversification as a risk management technique is that the individual risk of loss presented by each position is diluted by other holdings in your portfolio. For example, if your entire portfolio comprises a single £100k position in a single company and the price drops 20% on a profit warning, your portfolio will immediately lose 20%, or £20k. By comparison, a portfolio that holds five positions of £20k each would only lose 4%, or £4k, a significantly smaller value.
The fewer positions you hold in your portfolio, the more intense this concentration effect – otherwise known as volatility – becomes. In my own portfolio, I measure my success rate by my ability to select investments which return greater than 7% per annum over the long-term but my absolute hard line is not losing money on an investment. The more volatile the overall portfolio, the harder it is to hold when things aren’t working out. Even with all the work I put into stock selection, my personal success rate isn’t 100% which would guarantee at least one of the five would lose money.
The question would then become how much – of the losing investments I’ve made over the years, some have been relatively pain-free, costing only 5-10% of the initial investment, but others have been absolute wipeouts (see Carillion at 95%, Saga at 86%, or Ted Baker at 72%). If we take the worst example, Carillion, a portfolio of 1 would have lost as much as 95% of its value, a portfolio of 5 would have lost 19.9% of it’s value, but my portfolio lost…0.025% of its value when I sold out of the worst investment I ever made.
This dilution is important protection for a portfolio manager – as the returns that come from individual positions don’t really matter as much as the overall portfolio return. By diversifying your portfolio enough – but not too much – you can still afford to suffer a few significant losers and still come out with a strong overall result year after year. For example, even if with some of my huge losers (which I categorise as anything over 40% capital loss), my long-term compound annualised growth rate is sat at a respectable 7.3%.
(NOTE: This is against a five year target of 7.5% and a long-term goal of 10-15%)
Many investors I speak to overlook this and as a result they have significant stress when one of their stocks has fallen 40% or more, despite it being part of the game that many of our investments will not work out. This fact drives a good portfolio manager to utilise proper risk management techniques such as position sizing, diversification, hedging and the like, to ensure that their overall portfolio does well, even when some individual investments fail to work out.
Can a diversified portfolio be a bad thing?
On the flip side, if you diversify your portfolio too much, then individual positions fail to meaningfully add to returns. In a portfolio of 75 positions of equal weight, each position would be worth on 1.3%, meaning that even if it increased by 100% (not all that likely), it would only at 1.3% to your returns. Even more like, some positions would begin to overweight relative to others in the portfolio, meaning that that smallest would be worth less than 1%, generating miniscule contributions towards overall returns.
As such, the fewer positions you hold in your portfolio, then the easier it becomes to outperform the market as a whole. For example, on the Twin Petes Investing Podcast, we are running a competition where listeners were invited to submit a fantasy portfolio of five companies. Each month, the portfolio that has generated the largest return that month wins a prize, with a big prize at the end of the year for the portfolio that has performed the best overall.
For the most part, the winners of the monthly prizes seem to be carried by a single position that absolutely explodes – an oil exploration company that rises 300% after striking oil, or a tiny biotech company that lands an enormous client and doubles in value overnight. As the portfolios are limited to five positions, these enormous returns flow straight to the bottom line and often outweigh two, three, and sometimes even four other positions that decline over the same period.
Unfortunately, things are not that simple in real life, and such concentrated portfolios are also incredibly volatile – the shares that skyrocket one month tend to drop 30, 40 or even 50% the month after as shareholders take profit. If you attempted this approach with your own portfolio, you might get lucky one year and generate double digit returns but you could also expect to have some dreadful years with returns far lower than if you held a larger number of stocks.
As such, I try to think about the number of positions in my portfolio in terms of keeping mentally resilient and comfortable during bear markets or when bad news about an individual holding might be released. If I had 20% of my portfolio in a single company and the share price dropped 10% in a day (not an uncommon occurrence with small caps), I would be absolutely frantic about the financial impact and desperate to stop any further damage by selling my holding at any price I could get. In a world where shares can fall 25 or 30% over a few weeks due to market weakness but then go on to return 150% over the next 18 months, this would be financially devastating for my long-term returns.
Likewise, I also consider my ability to properly maintain an understanding of the businesses I’m investing in – following their RNSs, watching interviews with the management, monitoring their industry news and company performance, and also keeping an eye on the price charts. In a world with many competing demands on my time, I can’t spend every hour of every day just keeping on top of my portfolio, but it does require my time to manage effectively. The key consideration for investors is that they build a portfolio that suits their needs and psychology – just because I’m comfortable holding 44 positions doesn’t mean they have to.
You also have to take into account your interest in the management of your portfolio – this will change over time. When markets are going up and every time you log in your positions are valued slightly more than last time, you will feel fantastic and want to do more and more – but don’t forget that the reverse is also true.
How enjoyable will you find it logging into your account for six months and watching the value of your portfolio declining? Will you still want to take the long-term view on a position when every update seems like another disaster that should have been avoided?
Now, the obvious retort is to say that it doesn’t matter whether you like checking in on your portfolio, if you’re going to have one, it will need managing. The problem with this is that none of us like doing things we don’t enjoy – and the risk is that we start “looking the other way” at exactly the moment when our portfolios need us the most. The fewer investments you hold, the less likely something is to go really wrong, but that danger is never entirely eliminated.
Finally, the fewer positions in your portfolio, the fewer trades you are likely to execute trying to manage them. For example, in a portfolio with 40 positions, if you top every position up once a year, that’s 40 individual sets of trade costs, plus stamp duty and possibly FX fees. On a conservative basis, let’s assume that you can trade for a flat £5, all in (I hope you’re not with Hargreaves…) and so this would cost you £200 a year in fees. If you invested that money at 5%, it would be worth £329 after 10 years, or £541 if you managed to get 10% a year on it. Now imagine doing that every single year for 40 years – that’s £8,000 in trading costs, or an eye-watering £26,000 if you invested it at 5% over the same period.
Obviously, this maths isn’t perfect – you’d have to account for a variable return over time, but you get the idea. Costs are…well…costly!
So what is a good number of positions for the average portfolio?
My own portfolio contains a little over 40 positions – 44 including cash – the smallest being a 0.7% holding in abrdn European Logistics Income, a 0.8% holding in the catastrophic Digital 9 Investment Trust, and a 0.8% position in the perennially disappointing Vodafone.
The first two of these are what I would describe as “special situations” in the portfolio, with the first two going through a wind-down process which is expected to return a greater value than selling the shares on the open market. As such, forcibly selling them to hit an arbitrary target doesn’t seem particularly sensible, but I’ve been coming around to the idea that I am perhaps too diversified and am gradually trimming the portfolio to bring it down to under 40 positions.
This isn’t something I’m rushing to do, mainly due to the fact that interest rates are at 10 year highs so I expect my most rate-sensitive positions to respond positively over the next 12-18 months as rates are expected to fall. Despite this, I’ve been gradually selling positions over the last six months in less interest-rate sensitive holdings, including completely exiting my positions in Centamin, Hargreaves Lansdown, Darktrace, and Smoove the latter two of which received takeover offers.
I am also less than enthusiastic about a small position I have in NCC Group, which popped 10% at the end of last week on news of a £66m disposal of a “non-core business”. The business has been a tepid underperformer for several years and I really struggle to get enthusiastic about it – usually a good sign that I ought to sell and move on, having held since 2021.
Tritax Big Box REIT is an investment I inherited after they acquired UK Commercial Property REIT. I already have logistics exposure through much larger positions in Warehouse REIT and Urban Logistics REIT and am not convinced I really want to own this one as well. As such, I can see it exiting my portfolio in the next twelve months as falling interest rates should boost its valuation.
These two exits will take my portfolio down to 42 positions – still a high number – but one I’m happy to live with for another six months as in the past one of my biggest mistakes is selling investments and then watching the price climb after I’d done so. Despite my slightly bloated portfolio, due to my “three tranche” approach, I am overweight the positions in my top ten relative to others, and so these have a slightly outsized impact on returns. Of these, three are diversified funds including the S&P500, Stewart India Investors, and a UBS MSCI Switzerland tracker. My investment in Team Internet Group holding is also doing well, being up 116% since I first opened it and being worth around 5% of the portfolio as I’ve gradually averaged up into it. This means that value changes in the company have a larger impact than movements in holdings like DGI9 and Vodafone (thank goodness) which have been less successful.
The weakness of the pound relative to the Dollar and Euro, and the “stability premium” being provided by the Labour party also continue to make the UK an attractive target for acquisitions and I expect the next six to twelve months to continue the steady stream of takeovers. I hold three copper miners – Atalaya Mining, Anglo Asian Mining and Central Asia Metals – any of which could be taken out by a larger player very easily. Likewise, I hold several asset/investment managers including M&G, Phoenix Group, Aviva, Legal & General, Polar Capital, and City of London Investment Group, any of which could merge or be acquired by another player in the market. I hold none of these companies on the proviso of a takeover – I’d be equally happy to hold them for another ten years from today – but they all present attractive targets for international buyers.
Even then, holding this many positions is likely to create duplicative effects – where individual position returns are highly correlated. My rule of thumb for managing portfolio diversification is therefore to firstly consider the perfomance of the underlying business I hold (if persistently weak, I’m likely to divest) and second to look at whether I hold anything of a similar nature (not always a cast iron reason to divest, but a good one). The precise number of positions fluctuates over time. For example I’m likely to hold more during the bottom of bear markets as I open new positions in temporarily weak names), and gradually sell out of some of them as valuations recover (or as the underlying businesses fail to do so).