One of the keys to investing success is diversification – at least according to conventional wisdom. Diversification certainly has its place.
But there’s a myth that portfolio diversification by itself is inherently good. That myth can push investors into buying underperforming small-cap index funds.
I have a love-hate relationship with small-cap stocks.
I love the asset class and the huge upside potential of individual small-cap stocks. I also feel strongly that investors need to have exposure if they are investing for the long-term.
Is there such a thing as too much diversification?
The short version of the portfolio diversification myth is, as Warren Buffett once said, “Diversification is protection against ignorance.”
If you have no idea what individual stocks you should buy (i.e. if you are ignorant, to use Buffett’s term) then yes, you can gain broad exposure to an asset class by buying an index fund (protection).
But you’re going to get a lot of junk mixed in with the gems.
If you can screen out most of the junk and allocate more money to the gems – i.e. replace ignorance with knowledge – then you will absolutely destroy that overly diversified index over time.
In short, again to quote Buffett, portfolio diversification “… makes little sense if you know what you are doing.”
This cuts against the conventional wisdom that diversification is good!
But that wisdom is only partially accurate. In reality, the benefits of diversification are substantially reached when an investor owns around 20 to 30 stocks.
That’s not to say investors shouldn’t own more than 30 stocks. But if they do, they should do so knowing that the incremental portfolio diversification benefit of each additional stock goes down after that 20 to 30 stock threshold is crossed.
That’s especially true if they are blindly buying dozens if not hundreds of low-quality stocks, which is what arguably happens when you buy a small-cap index.
I could go into details of why there are so many junk companies in the small-cap index. But that’s a different subject.
The gist of my message today is that investors who wish for exposure to small caps are far better off constructing their own portfolio of 10 to 20 high-quality small-cap stocks and holding those – with appropriate replacements as needed – over the long-term.
What types of small-cap stocks should you look for?
I prefer growth names that offer pure-play exposure to secular growth trends, have a solid business model, a history of successful product launches and/or acquisitions that increases their addressable market, and a rapid growth rate, with a rational path to profitability, if they are not yet there.
These are the types of stocks that are likely to go through the inevitable corrections that will come and go when you’re invested for the long-term, and still come out the other end providing market-crushing returns.