Returns are invariably the hero of a portfolio. Risk management, which is positioned as a second lead, typically works in the background. However, it is evident that the cushion and comfort that good risk management provides, really determines the success of the portfolio strategy.
Diversification- The only free lunch
Risk is also a second lead as it can be managed with some commonsense and complex mathematics. Commonsense adages like ‘not putting all eggs in one basket’. And complex mathematics, like the one proposed by Nobel laureate and father of modern portfolio theory Harry Markowitz.
Diversification in fact is the only free lunch in investing an insight, attributed to Mr. Markowitz. Diversification can help eliminate unwanted specific risks ( un systematic risk).
If you are investing in equity, you will need to live through the g-forces of the markets (systematic risk) but surely you can get rid of the avoidable specific risk. These are risks pertaining to having exposure to single company or single sector.
Optimizing Risk
Managing risk doesn’t mean holding every listed stock in the market#. A very large number of stocks in your portfolio can lead to over diversification that can not only blunt your returns but add to your costs managing the portfolio.
You do not need to drink the ocean or have every stock in your portfolio get rid of unsystematic risk#. In fact, that may just lead to losing the character of your portfolio.
How Many Stocks Do You Really Need? Finding the “Goldilocks Zone”
Our research confirms that adding more stocks to a portfolio does reduce its overall risk. However, the benefits are not infinite and follow a clear law of diminishing returns.
Think of it like adding pillars to support a roof. The first few pillars provide a massive increase in stability. As you add more, the structure gets stronger, but each new pillar adds less support than the one before it. Eventually, adding more pillars makes no practical difference.
Our analysis of 100 portfolio simulations found the same effect. We took top 200 stocks as our universe and created 100 random portfolios. In each portfolio we progressively added stocks and checked the impact of the addition on the overall risk.
Here is the analysis of our study.
- The first 10 stocks are the most critical pillars, dramatically reducing portfolio risk.
- From 11 to 22 stocks, you’re still adding meaningful stability, but the effect of each new stock is smaller.
- Beyond 22 stocks, the structure is already stable. Adding more stocks provides almost no additional risk-reduction benefit.
The colored lines show the 100 simulations.
Equity Advisory at Vasupradah:
Vasupradah provides Equity Advisory services built on a foundation of disciplined risk management. We design portfolios that reflect your personal risk profile and actively manage them to ensure that they meet your investment objectives.
#By the way, holding all stocks in the market is also a strategy to chase only beta.