Risk and Diversification: Comparing Fund and Individual Security Investment Strategies

Intro:

Individual security selection has always been the foundation of Narwhal’s investment strategy. Because of the emphasis we put on this strategy, we naturally receive a number of questions on the topic. One question that has come up recently is whether or not it is riskier to invest in individual securities compared to funds. This is an interesting question and one we thought would be worth unpacking in this format as it offers us the opportunity to explain the conviction we have in our investment method.

The reason for the question:

The idea that owning individual securities could be a riskier investment practice than owning funds is more than likely derived from the concepts of concentration risk and diversification. Concentration risk is risk that an investor takes on by putting a large percentage of their assets into a small number of positions. Investing in a highly concentrated portfolio is a dangerous practice that can unnecessarily expose investors to big swings in their portfolio’s value. Diversification is the method through which you eliminate concentration risk. By holding a number of companies across different industries in a portfolio, you greatly reduce the risk of realizing losses if one company or one industry were to struggle. The reason funds are often viewed so favorably by investors when considering this concept is due to the ease and effectiveness in which they provide diversification. Funds allow investors to gain exposure to hundreds of companies simply by owning the fund’s shares. Holding huge numbers of stocks using an Individual stock selection strategy isn’t practical, so can we conclude that an investor can attain superior diversification through a fund strategy compared to a stock picking strategy, and thus determine that funds are a less risky method of investing? The answer to that question depends on the number of investments it takes to create an adequately diversified portfolio.

What is the magic number?

Diversification is a complex topic. It seems logical to think that the more companies you own within a portfolio, the more diversified you are and the more protected you are from concentration risk. If this were the case, it would be hard to argue that you could replicate the benefits of owning funds by implementing a stock selection strategy being that it isn’t feasible to own hundreds of individual companies within a portfolio. However, more doesn’t necessarily mean better when it comes to diversification. Within the concept of diversification, the idea of “diminishing marginal benefit” exists. This concept means that each additional stock you add to your portfolio reduces the diversifiable risk by a smaller and smaller amount each time. When you have one stock in a portfolio, you are fully concentrated in that one position and your risk is high. By adding a second stock, your concentration is reduced significantly and so is your risk. The same goes for adding a third, and a fourth, and so own, until you eventually hit a point when adding an additional stock to your portfolio doesn’t provide you with measurable benefit. At this point you are fully diversified and, in actuality, adding additional stocks could begin to detract value from your portfolio instead of adding it. So, if more doesn’t necessarily mean better, what is the correct number of stocks to own in order to be adequately diversified? Opinions on the answer to this question vary. As I google this question right now, I see one result that quotes a finance professor from NYU who says that owning 20-25 stocks constitutes a fully diversified portfolio. The motley fool has an article that claims that 20-30 stocks inside a portfolio offers the desired level of diversification for an investor. Another search result says the magic number is around 50 stocks. Some detailed studies claim that holding as few as 15 stocks achieves a 90% reduction in diversifiable risk, while other studies claim that number is closer to 40. There is no true consensus on the perfect number to achieve full diversification, but a range of somewhere between 15-50 stocks seems to be where most fall, according to most sources. If ideal diversification can be achieved by holding a range of somewhere between 15-50 stocks, it becomes very attainable to have a diversified portfolio through an individual stock selection strategy. So, if the diversification between a fund comprised of hundreds of companies is not materially different than the diversification of a portfolio of 15-50 stocks, are they equally risky investment strategies? Before offering Narwhal’s view of the risk of funds and individual stock portfolios, I wanted to include the perspective of a critic of diversification.

Warren Buffett’s View:

Despite clear evidence of the advantages of diversification, some still don’t utilize this method. Warren Buffett is one of those individuals. Buffett has a unique take on diversification, one that we certainly don’t endorse, but it does offer some interesting perspective. Buffett has been on the record many times saying that diversification is ridiculous and that it is “a protection against ignorance.” He explains that he doesn’t think diversification is necessary if you invest in “wonderful companies” as he calls them. He claims that wonderful companies are operated so well that they are insulated from “the vicissitudes of the economy over the long term” and diversification only lessens your exposure to those wonderful companies. He continues saying that there are only a few great businesses in the economy at one time, so why would it be smart to take money away from a company that he believes in, that might be his best investment idea, in order to invest in a company that he would consider his 50th best idea solely for the sake of diversification. Again, while I can’t say that I agree with his sentiment (although the strategy has certainly brought him plenty of success), I do think there is some underlying truth in his message. Buffett is saying that he values investing in great companies over a broad portfolio that holds average companies for the sake of diversification. This is something that Narwhal’s investment strategy aligns with at least at some level and is a key aspect as to why we prefer to hold individual securities over funds.

Where does Narwhal land on all of this?

Unlike Warren Buffett, Narwhal still values the benefits of diversification. It is an important part of quality portfolio management that protects the investor from unnecessary downside risk. Because of this, we believe that a well-constructed portfolio should hold anywhere from 30-50 companies in order to ensure proper diversification, which is a range that isn’t overly difficult to attain through individual stock selection and can easily be attained through holding a fund. At the same time, we agree with Buffett that investing in good quality companies that you understand at a fundamental level is a vital part of successful investing. This is the central theme of individual stock selection but is virtually impossible to practice when investing in funds. Within the structure of a fund strategy, you aren’t able to thoroughly understand all the companies that are held within a fund’s portfolio because the number of companies being held is too vast. The time and effort it would take to research hundreds of companies isn’t something we have the capacity to do. This leads many fund investors to invest blindly into companies, exposing themselves to additional risks that individual stock investors don’t face. Stock selection allows you to pick what you believe to be the highest quality companies at reasonable valuations. With diversification between the two strategies being equal, we prefer the ability to hand pick quality companies and avoid exposure to companies we don’t understand, which is why we believe that individual stock selection is the superior investment strategy.

There are additional reasons as to why we prefer stock picking over fund investing (we have touched on a few of them in previous blog posts), but there is one more that I would like to highlight here. It’s an additional point that Warren Buffett brings up in his conversation on diversification and is something we certainly align with him on. Buffett says that holding an excessive number of stocks in a portfolio in an attempt to diversify pulls you closer and closer to being average. He means that the more companies that you hold, the closer your portfolio reflects the market, and the closer your portfolio is to the market, the harder it is to achieve returns that are different from the market. Warren Buffett doesn’t want his returns to be average, he wants them to be exceptional. He understands that holding funds that represent the broader market doesn’t allow for the outperformance he desires. We share that same drive to achieve differentiated returns, and we know that we have the chance to do so through quality individual stock selection.

Link to the Warren Buffett discussion: