How many ETFs are enough?
Can you have diworsification?
It’s the evil cousin to diversification in your portfolio.
Diworsification is the term that was popularized by Peter Lynch in his book One Up On Wall Street – when he discussed that some companies tend to expand into areas widely different than their core business. Over the years this diworsification term has been leveraged to describe some investors who believe they are diversifying their assets but may be doing more harm than good in the process. This term has also used in context of holding a concentrated basket of stocks (say 10 or 15) and believing this is a better approach to returns beyond owning hundreds if not thousands of stocks from various sectors and countries (i.e., indexing that you can read about here).
Regardless of the context associated with diworsification, or any other term that suggests a portfolio is far from optimized, you can probably appreciate that most investment choices should try to achieve the following:
a good risk/reward trade-off for the investor such that this choice aligns with their financial goals and objectives while combating a variety of long-term market conditions.
This means depending upon your goals your financial decisions could be vastly different than your neighbour, your friend, your co-worker, your family and the list goes on…
So, today’s post will highlight how many ETFs might be enough for your portfolio, given some recent reader questions in my inbox and how I use ETFs for my own portfolio. Your mileage may vary!
Hi again Mark,
I’ve looked at the Canadian Couch Potato model portfolio for ETFs which proposes only 3 ETFs as you know. What is your rationale for using many ETFs versus just a few?
I’ve read on your site you own Vanguard’s VYM ETF. What not another ETF? Furthermore, how many ETFs should you own anyhow?
Indicators of diworsification
Beyond the obvious such as portfolio/investor confusion, increased portfolio management costs and lowering your portfolio returns, here are a couple of indicators that you might have diworsified your portfolio:
- You own too many stocks from the same sector. Example, owning just Canadian bank stocks is probably insufficient to weather a variety of long-term market conditions. To avoid individual stock or sector risk, you should consider owning many companies from many sectors to decrease your investment risk in any particular company or sector.
- You have too many individual stock positions. I recall from “The Intelligent Investor” (1949), Benjamin Graham suggested owning between 10 and 30 different companies to adequately diversify a stock portfolio. That guidance was provided decades ago. That guidance is nowhere near what Burton Malkiel, an investing guru, believes is sufficient. (It should be noted there really is no clear consensus on how many individual stocks are enough but suffice to say 10 stocks might be too few and anything approaching 100 or more is likely too many for any investor o keep track of.)
“Wide diversification is only required when investors do not understand what they are doing” – Warren Buffett.
Fair Warren, but there is nobody like you!
So, how many ETFs are enough?
If we go back to the earlier thesis that investing involves risk management, such that we should make our financial choices so they are aligned to our financial goals (while combating a variety of long-term market conditions) then you can likely accomplish this with just a few funds or Exchange Traded Funds (ETFs) in particular. That means many financial experts (who are fans of index investing) generally endorse owning:
- A domestic stock fund
- A U.S. stock fund
- An international stock fund
- A domestic bond fund.
Again, I use the word “many” with great discretion because there is also no clear consensus on how many funds nor more importantly in what allocation are those funds necessary for all investors. Case in point:
Some experienced investors might already know that David Swensen is the Chief Investment Officer of the Yale Endowment Fund, one of the most successful institutionally managed portfolios in modern financial history.
Just so you know…his asset allocation is very different than any Canadian Couch Potato model!
Is your portfolio going to flop long-term if you invested in just the S&P 500 and not any Canadian stocks or international stocks?
Is your portfolio going to be a massive failure long-term if you only invested in our Canadian market and held some bonds to combat market down turns?
Hardly. If you keep your investing costs low and stick to your investing plan I suspect you’ll do just fine regardless.
The truth is, over many years of investing, equity returns are correlated. Conversely, equity returns should be greater than those delivered by bonds and certainly cash long term. Why? Well, stocks are an investment in a future that is very, rather, extremely unknown. This means their upside should command a good return! Bonds are in simple terms a loan. While both stocks and bonds can fall through the floor at the same time, equities by and large have a greater upside. Remember risk and returns are related. With stocks you’re taking on far more investment risk for more potential reward by holding them over bonds and definitely over cash hoarded under a mattress.
Image source TaxTips.ca
“The above table shows before-tax returns. The big difference between the returns on the S&P 500 and bonds or T-bills becomes even bigger after tax. The interest is 100% taxable every year. Most of the return on the S&P 500 stocks would be capital gains, which is only 50% taxable, and is not taxable until the investment is sold.”
How many ETFs do I own?
Only a couple right now.
For dividend investors like me ample diversification can be an issue. Always remember with investing: “it is all too often true that the same things that maximize your chances of getting rich also maximize your chances of getting poor.” – Financial historian, celebrated author and neurologist William Bernstein.
“The crux of your success will be selecting leading companies’ stocks and then holding on to them for many years. While you cannot go to sleep, and there is a place for monitoring, there is no reason to panic if a firm has earnings that fall short in a given year or two. This is quite a normal phenomenon.” – Stephen Jarislowsky, The Investment Zoo; author, billionaire businessman, philanthropist.
Take XDV for example. This ETF is comprised of the 30 highest yielding dividend paying companies seeking to replicate the performance of the Dow Jones Canada Select Dividend Index, based on factors such as stable dividend growth, yield and average payout ratio. To date, I’ve managed to build a portfolio (on my own) that includes about 60% of the companies held by XDV. I now own a big proxy of this ETF. Either I can own XDV and pay the management fee of 0.50% or I can own many of the companies directly as a shareholder and never pay management fees. I’ve chosen the latter!
While I do own a number of U.S. stocks (JNJ, PG, ABBV are examples) I believe I’ll have better diversification and long-term returns by investing across the U.S. market using ETFs as part of my portfolio. Vanguard’s VYM is one of them. This fund has an income focus (that I will be relying on within 5-10 years); it holds almost 400 stocks, and it remains one of the lowest costs funds available with fees under 0.10%. At the time of this post we own about 500 VYM units and we reinvest all distributions paid to buy more units commission free every quarter; we earn 4 more units of VYM every 3 months.
For most investors, one or a few ETFs (i.e., less than five) is likely enough depending upon your goals, tolerance for risk and other criteria. For most investors, assuming these are broadly-diversified funds, likely a handful of ETFs is enough to own in my opinion. Anything more is likely approaching diworsification.
What do you make of ETFs? In particular, how many ETFs are enough to help you realize your goals?