We all want the best return possible from our investment portfolio, at the lowest possible "risk". (If you don't know why the word "risk" is in quotation marks, check out
this post!) The question that quickly emerges is "How do I do that?"
First off, there are many elements to investment risk. Some of these are outside the market, for example including:
market risk - could something happen to the economy which impacts the entire market.
geographic risk - the possibility that events, like weather or earthquakes, in another part of the world will affect your portfolio.
political risk - the policies of the government - in Canada and elsewhere - can impact investments.
industry risk - events impacting one company in and industry often impact many of the companies in that industry. For example base metal mining stocks tend to move as a group.
credit risk - the Bank of Canada loan rate and policies impacting how much money the bans can lend out have significant impact.
There are many more of these external factors. But there are also factors internal to the companies in which you invest, including:
business risk - is the company in a market segment which is growing that they can reach profitably?
management risk - can the management team deliver the results they project. How would the loss of one or more key players impact company operations?
legal risks - could a company product malfunction in a way creating significant liabilities for the company? Are products protected by patents?
competitive risks - could a competitor develop a new product which eliminates the need for the company's products, or steal away key personnel.
Again, there are many more internal factors affecting the risk of an investment.
To reduce the potential impact of these risks, prudent investors spread their money across multiple companies, industries, markets and geographies. Spreading money amongst different investments which are independent of each other is called diversification.
How many holdings should a portfolio have?
Modern portfolio theory indicates that a minimum of 10 "positions" creates good diversification, so long as the holdings are not similar. As an example, owning Microsoft and Facebook is not good diversification, since many external factors affect both companies. Mathematically, the best diversification occurs with 14 to 19 holdings. Increasing the holdings beyond this level tends to reduce the benefits of diversification, but diversification is still good with as many as 30 holdings.
As the number of holdings in a portfolio continues to increase, the return on the portfolio becomes closer to market performance.
Many mutual funds have a few hundred holdings. Since the managers of the funds must charge for the fund's cost including trading and research, mutual funds with large numbers of holdings generally underperform the market. For these funds, investors would be better to invest in Exchange Traded Funds (ETFs) which are fully diversified across the chosen index, but have lower fees.
In my practice as an investment professional, I chose mutual funds whose managers had "high commitment". These managers do a lot of research into their companies, make larger investments and stay with them for longer periods than lower commitment funds.
The key measures I look for are that the top ten holdings account for at least 45% of the fund's value and the turnover is below 40%. See the post on mutual funds for an explanation of these terms.
