Diworsification

Diversification is one of those things that everyone knows they should do, like eating vegetables or exercising regularly. And just like those other good habits, it's possible to overdo it.

The concept is simple enough: don't put all your eggs in one basket. By spreading your investments across many different assets, you reduce the risk that no single weak performer can significantly impact your overall portfolio.

Here's where it gets interesting: the benefit of diversification follows the law of diminishing returns. The first 20 or 30 stocks in a portfolio do the heavy lifting in terms of risk reduction. After that, there is an argument about getting negligible benefits while piling on complexity, costs and the very real problem of diluting returns. This is what Peter Lynch famously termed as “Diworsification” - the drawbacks of being too diversified.

Spreading your money across different asset classes, geographies and sectors can reduce volatility to smooth out the ups and downs, but only to a certain point. Once you’re holding a certain number of stocks, adding more tends to make less difference for reducing risk - as the chart below shows.

Diversification can do a lot to reduce your risk exposure, but it can’t protect you from everything. At some point, the only risk left is the risk of the market itself for that asset class which is something you take on anytime you invest in listed assets.

The Case for Concentration: 100 vs. 1,000 Stocks

Research has consistently shown that most of the unsystematic risks, the risk specific to individual companies, can be eliminated within a concentrated portfolio. So, what’s the difference between owning 100 stocks and 1000 stocks? In theory, not much in terms of risk reduction as you've already diversified away most company-specific risk with 100 stocks, however the returns can be quite different.

For example, with 100 stocks, you might still be able to maintain some level of familiarity with your holdings. You can reasonably follow the businesses you own, understand their competitive advantages, and make informed decisions about when to buy more or sell. Multiply that and it might be impossible.

Then there is the trading cost and any holding cost. Many platforms charge a minimum per trade, so your costs of acquisition of a larger number of stocks could be significantly higher for the same investment amount. Add in the complexity of tracking and analysing so many holdings, and it could be overwhelming.

Let’s look at some actual numbers. We'll compare a concentrated portfolio (fewer holdings) against a more diversified portfolio (more holdings) to see whether the additional diversification actually paid off.

The Australian market provides a clear example of Diworsifcation in action. Over the past 10 years, the S&P/ASX 100 (representing the top 100 companies) delivered a total return of 179.82%, with an annualised return of 10.83% versus the S&P/ASX 300 (a broader index with 300 companies) which returned 174.55%, with an annualised return of 10.62%

Let that sink in for a moment. By tripling the number of holdings from 100 to 300, investors actually underperformed, all while taking on more risk. As shown below, the 10-year annualised risk was 13.2% for the ASX 100 versus 13.4% for the ASX 300. So, what exactly did those extra 200 stocks accomplish? Not much, except besides more risk, underperformance and complexity.

Looking back over the past 15 years, the S&P/NZX 20 (the 20 largest NZX-listed companies by market value) has looked a lot like the S&P/NZX 50 (the 50 largest). In fact, the S&P NZX 20 makes up approximately three-quarters of New Zealand’s listed equity market cap. So, if you own the NZX 20, you already own most of the market.

Since the S&P NZX 20 launched in January 2007, it has beaten the S&P NZX 50 by 1.23% per year - more than 23% cumulatively over 17 years.

Both hold a diverse combination of sectors, (think power companies, transport, ports, and healthcare). This has meant that the correlation between these two indices (how closely they move in sync) has been high over time. The key difference is that the NZX 20 has delivered better performance in both up markets and down markets.

Again, by upping the number of holdings from 20 to 50, investors underperformed, all while taking on more risk as seen below.

The pattern is consistent across market cycles, time periods, and sector shifts - supporting the NZX 20 as a simple, investable, and resilient benchmark for long-term NZ equity exposure.

With only 10 stocks, The NZX10 is essentially a hyper-concentrated version of the NZX20. You get the same large-cap quality but with more single-stock risk and less sector balance. When those blue-chip giants perform well, the NZX10 can actually punch above its weight. However, that same concentration becomes a double-edged sword; a single stock falling sharply can meaningfully drag the entire index down.

By adding a further 10 quality large-cap companies and capturing more of the market's upside across a broader range of sectors, the NZX20 hits the sweet spot of concentration and diversification.

There's a reason global investors have poured trillions into US equities. The US market has consistently rewarded long-term investors. The returns are driven by a number of exceptional companies such as Microsoft, Apple, Nvidia, and Amazon.

The Broad Market Index does the same, but it also carries thousands of smaller, less durable businesses that drag on performance while adding volatility. You're essentially paying a "noise tax" for the illusion of broader safety.

Here's the nuance: even with US equities, the data suggests that concentration in quality beats breadth for breadth's sake. Over the past 10 years, the S&P 500 delivered a total return of 322.69%, with an annualised rate of return of 15.49% versus the DJI Broad Market Index which returned 306.35%, with an ARR of 15.03%. That’s more than 16% of outperformance which is hard to ignore!

Again, the Broad Market Index carried more risks than the S&P 500 across every time horizon as shown below. These charts offer an important reminder: once you have bought into the strength of the U.S. market, owning more of it does not necessarily mean you own better.

First, understand that diversification is essential, but more is not always better. If you're a professional investor or someone willing to do serious research, a portfolio of 15-30 quality businesses might be appropriate. If you're a casual investor, a few low-cost index funds as the entirety or core of your investment might serve you better than trying to pick individual stocks.

Second, quality beats quantity every time. The temptation to keep adding positions is strong, especially when you read about a hot new stock tip. Resist it. Jack Bogle, the founder of Vanguard, spent his career advocating for broad diversification through low-cost index funds. And you know what? For most investors, Jack was absolutely right.

The index fund approach gives you broad diversification at minimal cost, with no need to research companies or make trading decisions. It's an ideal solution for people who don't have the time, resources, and tools to become investment experts. Even for experts, it can be challenging to perfectly diversify and position their portfolios.

Like most things in life, there's a sweet spot where you have enough diversification to manage risk but not so much that you dilute your returns and overwhelm yourself with complexity or costs. You don't need to own the world to be a successful investor. You just need to be able to invest in quality businesses, understand what you own, and hold them for the long term.