If you own one stock, your “portfolio” will almost assuredly be rather volatile. If you own two stocks, especially if they represent significantly different companies, overall volatility will be less. As you keep adding more stocks, near-term volatility will continue to decline, but at an ever-decreasing rate. Beyond some point of diversification, you will ultimately be left with characteristic stock market volatility, which simply cannot be diversified away. Thus, if your portfolio contains numerous stock mutual funds, each of which is diversified, you will not achieve a meaningfully lower amount of short-term volatility than, say, a portfolio of several dozen different stocks. However, a portfolio of numerous stock mutual funds is very likely to be unable to sufficiently differentiate itself (due to its very broad diversification) so as to outperform a benchmark index. Put differently, a portfolio of many stock mutual funds won’t add much, if anything, in terms of volatility reduction, but it certainly can—and likely will—constrain returns. Nevertheless, portfolios of numerous stock mutual funds (or exchange-traded funds) are sometimes marketed to appeal to the elusive low-risk, high-return objective. So are strategies of “tactical asset allocation,” “smart beta,” “private equity,” or a seemingly countless number of recycled approaches and gimmicks. However, at the end of the day, the data on investment returns is quite clear: Without 20/20 hindsight, investors simply can’t achieve predictable low-risk, high-return results, no matter what the marketers may say.
Aug 2014