Make Portfolio Diversification a Key Investment Tool

Adding ETF's and global stocks makes financial sense

   

If you have been with me long, you know that I have long advised 32-stock portfolios. With a 32-stock portfolio you achieve 90% of the diversification of owning all NYSE-listed stocks—or at least you used to. My 32-stock recommendation was based on studies of the U.S. stock market in an era when high-frequency trading and ETFs didn’t play a dominant role in equity markets.

Today, high frequency trading accounts for 70% of total volume, with ETF volume making up as much as two-thirds of all trading volume. ETFs are a fixed basket of stocks. If you invest $1 million into the SPDR S&P 500 ETF, a portion of your investment goes into each of the 500 stocks in the index—pushing up their prices in tandem.

So then, as ETF volume increases, it would be natural to expect an increase in the correlation among stocks. And that is exactly what has happened over the last decade. After remaining fairly stable in the 1980s and 1990s, the average correlation among S&P 500 stocks has almost tripled in the last ten years. This increased correlation means that a 32-stock portfolio no longer provides as much diversification as it once did. To achieve maximum diversification today, a larger portfolio is necessary.

A larger stock portfolio can also simplify the task of crafting a globally diversified portfolio. Not long ago, an equity portfolio made up of strictly U.S. stocks provided ample diversification. Today, a properly diversified portfolio means a globally diversified portfolio. There are about 40,000 publicly traded companies of size in the world. Over 85% of those companies are domiciled outside of the United States. In the context of an investment universe that includes 40,000 stocks, a 32-stock portfolio can be limiting.

To improve diversification and better cover the global equity landscape, we are expanding the size of Young Research’s Retirement Compounders portfolio. With the correlation among stocks still in flux, I am not committing to a fixed number of stocks. Instead my new target is no less than 32 stocks and no more than 64. As investors move from a 32-stock portfolio to a 64-stock portfolio, each additional name improves portfolio diversification. Once past 64 stocks, the benefits of diversification are minimal.

But for individuals such as your fine self, I continue to advise a 32-stock portfolio. Following even 32 stocks is beyond the scope of most investors. A portfolio any larger than 32 stocks is best suited for professionally managed accounts. But as I explained earlier, a 32-stock portfolio no longer provides the diversification it once did.

To remedy the problem, I am advising that all 32-stock portfolios should be supplemented with funds from my Monster Master List. With the change, you should own a 32-stock portfolio plus a handful of mutual funds and ETFs.


Article printed from InvestorPlace Media, http://investorplace.com/2012/07/make-portfolio-diversification-a-key-investment-tool/.

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