As we reviewed in the two previous posts, diversification is an effective way to reduce risk. If you own too many investments, however, there can be hidden costs without a material reduction in the risk of loss. These costs may include:
- Reduced returns which can increase the risk of not reaching your financial goals
- Unnecessary complexity
- “Too many eggs in one basket” to properly monitor the risk of loss for each holding.
Regardless of whether you are picking your own investments or paying someone to do that on your behalf, recognize that the potential benefits of individual stock selection are expected to decline as the stock holdings grow in number. Assuming this expectation holds true, defining your return goals can be paramount.
To help illustrate why defining your investment return goals is so important, consider this hypothetical investment scenario for an investor who needs to make a 10% average annual return to meet her long-term financial needs. The stock market in this hypothetical example consists of 500 stocks spread across 10 different industries. The investor’sinvestor’s portfolio consists of over 25 stocks diversified across the same 10 industries.
Because the stock market is trading at historically high valuations in our hypothetical example, future market returns are expected to be below 6% a year. Is there a high probability the investor will achieve average returns of 10% in this scenario? In our view, the answer is most likely “”no”” for these two reasons:
1. The portfolio’s expected correlation to the market: Since the investor has a diversified portfolio of over 25 stocks spread across the market, we would expect future returns and/or losses to be closer to market results. If the market went up or down 15%, the hypothetical portfolio would be expected to fluctuate in value similar, if not equal, amounts. In other words, we would expect the portfolio to be highly correlated to the overall market because it has so many holdings spread across the market.
2. High market valuations indicate lower future returns: Because the market is trading at historically high valuations in this investment scenario, future returns for both the portfolio and the market would be expected to be lower. If expected market returns are below 6% a year, 10% annual return expectations for a portfolio with over 25 stocks also highly correlated with the market may be unrealistic.
The previous example is, of course, hypothetical, and the future is always uncertain. There are, however, three fundamental principles to consider of the prior example when setting your investment return goals:
1. The more stocks you own, the more likely your portfolio will be highly
correlated with the market.
2. The more closely your portfolio resembles the stock market, the higher the probability the portfolio will produce results similar to the market.
3. If your portfolio is highly correlated with the market and valuations are high, future
returns would be expected to be lower.
While there is no perfect answer to the ideal number of holdings in relation to your investment goals, owning too many investments can increase the possibility of lower returns. We can help answer the question, “”Do I own too many investments in relation to my goals and risk tolerance?” To learn more, give us a call at 713-850-8900. We would be happy to assist you.
About The Goff Financial Group: As a fully independent Registered Investment Advisor, the Goff Financial Group is not owned or controlled by any bank, brokerage firm, mutual fund company or any other company. The company does not receive any fees or commissions from any financial products and works solely for its clients on a fee-only basis. Disclaimer: This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.