Why a diversified portfolio is easier to manage than a concentrated one

I’ve had a few conversations with investors recently about how time-consuming it is to run a diversified portfolio of hand-picked shares.  It seems obvious enough.  You have to think about the strategy, and you’ve got to find the shares, evaluate them and buy them.  Then you have to check every day to see what your shares are doing, what the economy’s doing, what the Bank of England’s doing, and all manner of other things.

A common response to all this work is to reduce the number of holdings down to less than ten so that each stock can be investigated deeply while removing the need to become a full-time analyst.

The downside of this approach is that the diversified portfolio becomes more concentrated, and more concentration means more risk if something goes wrong with one of your holdings.

So what alternatives are there?  Either we run a diverse, lower-risk portfolio with 20 or 30 stocks and spend all our precious time analysing companies, or we hold fewer than ten stocks and face massive losses if something goes badly wrong.

Fortunately, there is an alternative and, as is often the case, it starts by doing the opposite of what many other people do.

The passive investor’s secret

It is generally acknowledged that passive index tracking is the most suitable form of investing for the vast majority of people.  That’s because it enables investors to get a fair share of the stock market’s return for virtually no effort whatsoever.

Imagine, if you will, a passive investor who has their money split 50/50 between a FTSE 100 tracker and a UK government gilts tracker.  All year long, the portfolio’s market value bounces around, up and down, all the while with dividends and coupon payments flowing into the account.

For 364 days of the year, the passive investor is blissfully unaware of all these exciting gyrations.  But, once a year, the investor sees an entry in their calendar telling them that today is ‘rebalancing’ day.  In one fell swoop, they log into their account and adjust the two funds so that they are approximately equal in value once more (because, of course, during a year, the equity fund and bond fund will have changed in value to a different degree, and perhaps in opposite directions).

Total time taken: 10 minutes, once a year

For most people, this approach (although perhaps not necessarily that exact asset allocation) is about as good as it gets.  The effort required is almost zero, and the returns will probably be, in the long run, close to what you’d expect from a 50/50 stocks and bonds portfolio (something like 5 to 8 percent a year).

So how does the passive investor do this?  How can they ignore their investments all year long, and yet in the long term still reap better returns than the majority of active investors who are constantly watching their investments?

The secret is simple:

Own more companies

Yes, you heard me: own more companies.  That’s the secret to spending less time on your investments.  But how, I hear you say, can more stocks mean less work?

Let’s take it to the logical extreme and say that, by law, you had to have all your assets in just one company at a time.  You don’t have to own it forever, but if you decide to sell, you must sell the lot and pick a single company to move your money to.

Do you think you would research each potential investment closely?  Of course, you would.  You’d probably spend days, if not weeks, learning everything there was to know about the company, its industry and competitors, how it might be affected by the economy and all the other things that might positively or negatively affect that company’s future.

And once you’d bought it you would probably continue to read everything you could about the company, its industry and the wider economy, from RNS feeds to industry magazines and the infinite ramblings of the internet.

That’s entirely sensible.

But what if, on the other hand, you had to invest in 100 companies by law?  Then what would you do?  I think a very reasonable step, given the near impossibility of any single person tracking 100 companies to any meaningful degree, would be to invest in the FTSE 100 and forget about it.

Which is precisely what passive investors do.

Here’s a question: Do passive investors even know which stocks are in their portfolios, or even how many?  No!  They have no idea whatsoever, and they don’t care either.  There is no need for them to know because their portfolio will capture the general progress of the economy over time (the global economy in the case of the FTSE 100), plus dividends.

My point is this:  

The more stocks you own the less time you have to spend analysing and tracking them, because you have less chance that any one company will ruin your performance, and therefore each company is less critical to your overall results.

For example, our “defensive value” model portfolio holds around 30 companies, and in any given month, it takes me about one day to make sure it’s on track to meet its goals of more income and growth than the market, with less risk.

It really does take about one (whole) day a month on average.  It takes about one day to analyse a new investment from start to finish, but a new investment is made only every other month or so, so about half a day per month is spent on analysis.  The other half a day is spent on reviewing annual and interim results as they come in.

(Note that this assumes I’m using our stock screen and investment analysis methodology.  If I didn’t have access to those tools, then it would take quite a bit longer to track down suitable investments.  But the point still stands if you have your own screen and analysis methodology that are producing good results)

If you think that 30 is too few holdings for a relatively hands-off portfolio, think about how many stocks are in the DOW Jones Industrial Average (hint: it’s 30).  That index has been running for over a century and has consistently kept close to a 10:1 ratio with the S&P500, which of course, has 500 companies in it.  Perhaps the extra 470 aren’t really doing much for diversification?

So I would say that if you’re worried about running a diversified portfolio of 30 companies because it’s going to be massively time-consuming, then think about the DOW 30 and how passive and active investors have been tracking it for decades, with little or no effort.

[A couple of final points: If you actually like following companies in great detail every day, then, of course, this approach of having more holdings may not be relevant to you.  Also, don’t forget that with investment positions of less than £1,000, you’re going to be eating up a lot of your returns on commissions, so a higher number of holdings requires a reasonably sized portfolio too]

The inspiration for this post came from an excellent post on the Monevator blog: How to build a dividend portfolio