We began SOTW more than five years ago and have yet to reference the Dave Mathews Band (DMB). Not sure why … we fondly remember when the fresh sound of DMB exploded on the 90s college scene. Today, we hear DMB in elevators and grocery stores. Gone are the days of DMB being cutting edge, but we remain proud to be fans of the great song writing, improvisational live jams, and creativity that is DMB.
The song titled “Too Much” by DMB is not about stocks, but the tune inspired this SOTW as we discuss how many stocks is too many in your portfolio. Too much of anything can be a bad thing.
In the early 90s, DMB was cutting-edge music and stock pickers were still the titans of Wall Street. It was a time before Taylor Swift (TSWIFT) and Exchange Traded Funds (ETFs) ruled the world. Musicians playing instruments were considered a band and research was the foundation of stock selection.
The explosion of ETFs (index-funds) brought trillions of dollars into the fund industry and the marketers of these products used their marketing budgets to promote their products. With index funds came a decade of investors holding thousands of stocks in their portfolio. Further, having index-like returns and risk was acceptable and even recommended by “professionals.” And why not? With a 13 year period of near zero interest rates, the stock indexes performed exceptionally well. Do not get us wrong, we like ETFs in specific circumstances and own them ourselves. There is a use, but we do not believe they should be used exclusively.
The question posed today: how many stocks is too many? There is not an exact answer to this question, but we do believe the number is closer to 30 than 500 because it is possible to overdiversify. Consider the definition of the “law of diminishing returns” from Oxford.com below:
The Law of Diminishing Returns
- a phrase of diminish
For further evidence, we turn to the financial classic “A Random Walk Down Wall Street” by Burton Malkiel. This is the book where we first learned of the theory behind the proper number of stocks to include in a diversified portoflio. The following chart is from the book:
The chart illustrates that one stock is a risky portfolio. The second stock lowers the risk meaningfully. The third stock leads to even less risk, but there is a point when adding more stocks does not have more utility. In other words, proper diversification can be achieved with a thoughtful basket of around 30 stocks.
POP Quiz:
Q: How many stocks are included in the Dow Industrial Average?
A: 30 (same since created in 1896)
Let’s think about this matter in real-life terms. Imagine you are going to the store to buy apples. How many apples would you add to your cart before being satisfied with your odds of not having a rotten apple? It would be more than one and probably more than two, but where do you draw the line for having too many apples? If you overdiversify your apples, then the apples may rot before you can eat them all. Too many apples would be a burden. This is a similar concept when shopping for stocks.
Imagine holding 500 stocks in your portfolio from an analyst’s perspective. How can you take care of this many stocks? In addition to conducting research on over 500 companies, it would be difficult to convince us that all sectors are appropriate to own during different stages of the economic cycle. For example, would you want to blindly hold bank stocks during a banking crisis?
In conclusion, like DMB declares in the song, there is such a thing as “Too Much,” especially when it comes to stocks in your portfolio. While we appreciate the usefulness of ETFs, we believe there needs to be a balance. Owning a larger number of stocks does not displace the need for thoughtful research. While we frequently use funds as a tool to express a theme in our portfolio, we believe in down markets the merits of owning a proper number of securities is the appropriate strategy for a risk-conscious investor. Just like there is a world where TSWIFT and DMB can exist on your playlist, ETFs should be used sparingly with individual securities in your portfolio.
This letter is for informational purposes only. The content herein contains the observations and opinions of the author, is not intended to provide investment advice, and should not be relied upon for any investment decisions. Past performance is no guarantee of future results and information pertaining to our processes is subject to change at any time without notice.