Can Owning 100 Stocks Mean You're Overdiversified?

Warren Buffet famously said that a person should only be allowed to have 20 "chits," so that they can have no more than 20 stocks at a time. Most investors understand the need to diversify. If all your assets are tied up in only one stock, then you run the risk of losing everything.

But can over-diversification be just as bad? The answer, as we have found, is not necessarily. As of December 16, we collectively hold more than 100 different individual positions (in both stocks and ETFs). To the casual observer, such an amount is surely detrimental to our performance. After all, how can we outperform the markets when we hold the equivalent of 20% of the S&P 500?

It is true that if we were to pick 100 different random securities, our risk would likely go from being asymmetric (the risk that one specific security will fall) to being systemic (the risk that the market will fall). However, if those securities are aligned with one another, if they are likely to rise based on the back of similair catalysts, then the risks of over- diversification can be avoided.

As an example, we offer our "basket" of smartphone stocks: Apple (AAPL), ARM Holdings (ARMH), Broadcom (BRCM), Cirrus Logic (CRUS), Qualcomm (QCOM), and Skyworks Solutions (SWKS). These 6 companies are all exposed to the growth of the smartphone market, and the suppliers in this basket have exposure to both the Apple and Android (GOOG) ecosystems.

In order for us to realize profits off of these stocks, we need only be right in our thesis that the smartphone market will continue to grow. If the iPhone maintains its lead in the market, then every stock should do well. Apple will rise, and so will its suppliers. But, if Android phones finally manage to overwhelm Apple, the 5 suppliers in this basket will still do well.

For a company like Broadcom or ARM Holdings, it does not matter what kind of smartphone a person buys. All that matters is that they buy a smartphone with a Broadcom chip, or an ARM-based processor. The loss of business at Apple would be offset by increased business at Samsung (SSNLF) (or vice versa).

This basket of 6 stocks is, in reality, an investment in one idea: the growth of the smartphone market. In essence, it is a customized ETF that allows us to invest in a thesis that we have a great deal of conviction in. The same can be said of the rise of credit cards and electronic payments around the world. Our investments in Visa (V), MasterCard (MA), and American Express (AXP) are all investments in this idea, and as long as we are correct in our assumption that adoption of electronic payments will continue, then these investments should outperform the market.

In our view, simply looking at the number of securities in a portfolio is not enough to determine if there is a proper level of diversification. Holding 10 random stocks can be worse than holding 100 stocks categorized into 10 overarching "themes." And such an approach can lead to outperformance just as easily as holding a few stocks deemed to be worthy.

If you believe in the continued growth of smartphones, then the companies that are leveraged to every major platform (such as ARM Holdings, Qualcomm, and Broadcom) should all do well. And by choosing to invest in all of them, risk can be reduced. Overdiversification is a real risk that investors need to be aware of. But, it is not something that is truly linked to the number of securities in a portfolio.

If you hold dozens of stocks, and many of them are levered to the same global trends, then that is not over-diversification; it is prudent investing.