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Is beating the pros possible? Yes! In this six-part series, Jason Del Vicario, CFA, portfolio manager, and Steven Chen, MBA, analyst, at HillsideWealth | iA Private Wealth Inc. will explain why - and how - a concentrated portfolio of global high-quality stocks gives the long-term investor the best chance to outperform both broadly diversified indexes as well as professional money managers.

“Wide diversification is only required when investors do not understand what they are doing .... Diversification may preserve wealth, but concentration builds wealth.” -Warren Buffett

“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investments in mediocre businesses, only guarantees ordinary returns.” -Charlie Munger

First and foremost in this new series, we’d like to note that we strongly believe that equities should be the singular focus of the long-term investor. We define ‘long-term’ as money that isn’t required to meet one’s financial goals (be it lump sum or regular withdrawals) within at least the next five years. Money that is required within five years should be invested in asset classes such as GICs or short-term government bonds. Equities tend to outperform other asset classes over the long term because businesses can grow their earnings by increasing sales via selling more products or services and/or increasing prices. This increase in earnings power is not shared by bonds, GICs or other ‘fixed income’ securities.

Once an investor has decided how much of their investable assets to allocate to stocks, the next obvious step is to decide how many to own in a sufficiently diversified portfolio. We believe that a 15-25 position portfolio is ideal. This should be music to the ears of the smaller investor, providing a competitive edge.

A professional portfolio manager allocating billions cannot own just 15-25 positions - the career risk in underperforming an index is too great of a force. But the small retail investor can stick to that limited number of stock holdings. In addition, while the professional portfolio manager is generally limited to fishing in ‘large cap’ ponds, the smaller investor can leverage their scale advantage by fishing in less crowded waters. They are free not to follow the herd.

We believe that one should be singularly focused on high-quality stocks, using criteria such as return on capital and debt levels relative to equity (we’ll get into this in more detail in a future column in this series). A portfolio of 15-25 stocks will possess stocks meeting superior and more stringent factors than one with 100, 200 or 1000 positions.

There are two risks when one invests in stocks: market risk and stock specific risk. Market risk, or systematic risk, impacts the overall stock market while stock specific risk, or unsystematic risk, affects only a specific sector or company. If you’re invested in stocks, you can’t minimize market risk (for example, a 2008 financial crisis type event) but we will note that this risk diminishes as one’s holding period grows. Stock specific risk can be minimized by owning more than one stock. The risk or volatility of a portfolio of two stocks is lower than 1, 10 lower than two, and so on.

An investor who focuses on the prosperity of the underlying business over the long term can build a highly concentrated portfolio that is more diversified than many would think. Here’s an example: UK-based Bioventix provides crucial antibody technology for multi-national diagnostics companies. Whenever a patient has a blood test for vitamin D deficiency in Asia, Europe or North America, it’s likely that Bioventix is earning a royalty fee. The demand for those blood tests is largely recession-proof. Therefore, the company, despite its micro-cap status and only 12 full-time employees, can be a huge diversification contributor.

The reverse may also be true – a portfolio even filled with hundreds of different names can be only ill diversified (or sometimes called “naively diversified”). Think owning a basket of every publicly-traded department store and every airline company under the sun for the last decade.

Determining how many stocks may be ideal is best illustrated with a visual aid. Risk is often defined by volatility or standard deviation. Standard deviation speaks to how much a given signal (in this case portfolio returns) fluctuates around average returns.

When investing in stocks, market risk is always present; the only way to diversify away this risk is to keep your money under a mattress. Stock specific risk, however, reduces as we increase the number of stocks in a portfolio. The reduction is, however, not a linear (straight) function but rather curved or exponential. By looking at this graphic, generated by using data from the 2006 research paper authored by James Bennett and Richard Sias at SFU, we can see that 95% of a single position’s stock specific risk is eliminated by the 20th position while only a further 4% diversification benefit is achieved by the 100th position and an extra 1% by the 4000th holding.

We have scoured many academic papers on this subject and they generally all fall within the 15-25 position range as being the ideal number of holdings in a portfolio.

Stay tuned for our next installment in this series.

This information has been prepared by Jason Del Vicario, Portfolio Manager, and Steven Chen, Global Analytics Associate, for iA Private Wealth Inc. Opinions expressed in this article are those of the authors only and do not necessarily reflect those of iA Private Wealth Inc. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.