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How much stocks are the optimum diversification?


frommi
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I think the one thing I see is that concentration levels should not be used as an excuse to cut back on research.  You can look at great investors and see that they were concentrated into a handful of stocks and try to emulate that but you need to remember they were still doing their homework even when they weren't buying for a year or two.  I guess it comes back to the 500 pages a week or day or whatever it was.  You need to keep doing that, stay engaged, even if you hit whatever your concentration limit is.  There is always something better to buy so you need to keep looking for that other option.

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It depends upon your objective.  If it is capital preservation (from gains obtained elsewhere) then wide diversification (via index funds) is probably the best route.  If it is growth then concentration in what you know subject to limits such as the Kelly formula is probably the way to go.

 

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http://alphavulture.com/2015/01/17/diversification-is-underrated/

 

This forum member makes a case for diversification, I think his advice is much better for the majority of investors.

 

When you read the last sentence of his post you realize that he concentrates, too. For the majority of investors a broad based index fund is probably best, i agree. But the majority of investors probably doesn`t waste hours in this forum searching for ways to improve their performance.

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I think the one thing I see is that concentration levels should not be used as an excuse to cut back on research.  You can look at great investors and see that they were concentrated into a handful of stocks and try to emulate that but you need to remember they were still doing their homework even when they weren't buying for a year or two.  I guess it comes back to the 500 pages a week or day or whatever it was.  You need to keep doing that, stay engaged, even if you hit whatever your concentration limit is.  There is always something better to buy so you need to keep looking for that other option.

 

The funny thing is that the author has just done a backtest with statistical data. No reading involved, so there where probably value traps in the list that you could have avoided by reading the reports and thinking about the businesses. And still 5 stocks were enough to diversify that risk away and gave the maximum returns.

 

Portfolios ranged from 1 stock to 100 stocks, and stocks needed to have a minimum market cap of $200MM (inflation adjusted). Cheapness is defined as an equal weighted combination of a stock’s price/earnings, price/sales, EBITDA/EV, Free Cash Flow/EV and total (shareholder) yield.
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Couple of caveats:

 

1. The best _risk adjusted_ returns came from the 15 stock portfolio. Something roughly equal to what AlphaVulture is doing and quite different from 5 stocks.

2. The worst returns came from the concentrated portfolio with "bad" stocks. Whenever you pick stocks yourself concentration doesn't automatically imply you improve your performance, it just makes the outcomes more extreme. So you should be 100% sure you are a great stockpicker first.

3. As with any backtest I would be extremely skeptical due to survivorship bias, data cherry picking and data fitting. Lots of pitfalls.

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My personal experience is that with mechanical investing it's tough to beat the market. I have run quite a few test portfolio's with different mechanical strategies and I am unconvinced of their effectiveness.  Regardless, if I was to mechanical invest I would definitely go for diversity as you don't have the time limitations and my trading costs are negligible.  The only reason I would concentrate is because I only have so much time to read and do fundamental investing.

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To me, the best part of O'Shaugnessey's methodology was the rolling 12-month basis.  My portfolio currently has about 60 stocks, built up over a period of time, so by his study's definition, I can actually call it a 5-stock portfolio!  (Actually, even smaller, since the investments were made over the past 4-5 years.)  Am I concentrated, or over-diversified?

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