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Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio

October 27
00:54 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

How many stocks do you need to hold to avoid over-diversification? What’s the point of holding hundreds of stocks when all it becomes is a proxy for the market? Indeed, Warren Buffet has said, “I cannot understand why an investor 369547_5346_italian_soup_stock_xchng_royalty_free_300would put money into a business that is his twentieth favorite rather than simply adding more money to his top choices.”

We all know the success Warren Buffet has had holding only a handful of companies, but does his strategy sufficiently reduce unsystematic risk? Oddly enough, the prevailing academic literature supported Buffet when he first began to accomplish his above average performance returns. Today, the academic consensus appears to be roughly 30-50 stocks (2001, Campbell, J.Y., M. Lettau, B.G. Malkiel, and Y. Xu, “Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk,” Journal of Finance, 56, 1-43 and (2010) Hicham Benjelloun, “Evans and Archer – forty years later,” Investment Management and Financial Innovations, Volume 7, Issue 1, 2010, pp 98-104).

But how does this impact the real world of 401k investors? Would 401k investors see better returns if their mutual fund options were limited to portfolios of 30-50 stocks? Fiduciary News sought to answer these compelling questions by using the Morningstar database (performance through 8/31/11). We first screened for all no-load domestic large-cap equity funds with no 12b-1 funds and a “growth objective.” We then ran screens for all mutual funds with fewer than 50 stocks (“Optimal Holdings”) and with more than 500 stocks (“Overdiverse Holdings”).

We found the average mutual fund in the Optimal Holdings category held 36 stocks. With an average Beta of 1.02, it appears these portfolios came very close to mimicking the risk of the market (which has a Beta of 1.00). Over 5, 10 and 15-year reporting periods, the average fund in the Optimal Holdings category beat the S&P 500 by 1.20%, 0.93% and 0.23% respectively. So, these funds outperformed the market despite having a similar market risk profile. Incidentally, as an aside, the average Gross Expense Ratio was a whopping 1.68% – and they still performed significantly better than the index. Of course, this is an unfair comparison because we’re comparing actively managed funds to an index.

Instead, let’s compare them against other actively managed funds, in this case the Overdiverse Holdings category. Here, the average fund holds 730 stocks. Oddly, despite the larger amount of holdings, the average fund had a Beta of 1.06, indicating slightly more market risk versus the Optimal Holdings average. Over 5, 10 and 15 years, the average Overdiverse Holdings fund underperformed the market by 0.23%, beat the market by 0.29% and underperformed the market by 0.47%.

Comparing these two groups, the funds in the Optimal Holdings category consistently outperformed the funds in the Overdiverse Holdings category. Over a 5-year period, Optimal Holdings beat by 1.43% annually. Over a 10-year period, Optimal Holdings beat by 0.64% annually. Over a 15-year period, Optimal Holdings beat by 0.70% annually. Again showing the folly of looking at the expense ratio of a fund, the average Gross Expense Ratio for the underperforming Overdiverse Holdings category was only 0.62%, more than a full 1% cheaper than the average fund in the better performing Optimal Holdings category. Apparently, sometimes you do get what your pay for.

Remember, this is no mere academic study, these are actual portfolios with real track records. Granted, this is only a snapshot-in-time and the Morningstar database reflects a survivor bias, but presumably the survivor bias would benefit both categories. After all, we’re not comparing the results to an index.

Thirty or so years ago the interest in optimal portfolio size peaked. At that time, the issue of trading costs made it difficult to create portfolios with large numbers of holdings. In fact, investors once understood the foolishness of buying a handful or so of mutual funds for the sake of “diversification.” They then knew the dangers of building portfolios consisting of hundreds of stocks. These virtual indexes have lagged considerable behind actively managed portfolios in recent years. As a result, there is greater need for 401k investors to know to ask the question “How many stocks do you need to hold to avoid over-diversification?” Not only should this alert the 401k plan participant to the potential dangers of owning multiple mutual funds, it should also guide then towards selecting the appropriate fund.

Perhaps Warren Buffett gives us the answer when he says, “Diversification is protection against ignorance, but if you don’t feel ignorant, the need for it goes down dramatically.” (Lenzer, R. “Warren Buffett’s Idea of Heaven: I Don’t Have to Work with People I Don’t Like.” Forbes, October 18, 40-45, 1993.)

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th Deadly Sin – The Overdiversification
Part II: A Trip Down Memory Lane – Revisiting Portfolio Optimization
Part III: Overdiversification and the 401k Investor – Too Many Stocks Spoil the Portfolio
Part IV: Why Overdiversification Matters to the ERISA Fiduciary
Part V: How Plan Sponsors Can Help 401k Investors Avoid Overdiversification

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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