For its study, Nomura analysed historic stock returns of the MSCI All Country World Index. It created 20 separate random portfolios for various portfolios sizes (e.g. 20 x 1 stock portfolios, 20 x 2 stock portfolios, 20 x 4 stock portfolios, 20 x 6 stock portfolios, and so on), and calculated returns on a buy and hold basis.
As you can see on the chart below, the conclusion of Nomura's research is that the difference between the best and worst performing portfolios decreases rapidly when adding stocks to a portfolio until the portfolio size has reached approximately 20-25 stocks. As soon as the portfolio size increases beyond 40 stocks, meaningful diversification benefits even cease to exist at all.
“Approximately 90% of the maximum reduction in standard deviation of excess returns is reached by the time you have 40 stocks. This leaves an upper limit on optimal portfolio stock count of 40 stocks,” Nomura concludes, adding: “This is a robust pattern over the last two, three and ten years, suggesting the upper limit of portfolio stock count should be 40 stocks because beyond that the potential to achieve above average investment returns has substantially diminished.”
The consensus: overdiversification
However, Nomura’s conclusion isn’t yet conventional wisdom in the asset management world. According to data from eVestment cited by the Japanese asset manager, 75% of investment funds listed globally hold more than 40 stocks. A sample of 499 European equity funds that publish a stock count every month, provided to Expert Investor by Morningstar, gives even stronger evidence: only 19% of those funds hold 40 stocks or less. Moreover, Nomura has itself at least one fund defying its own recommendation to limit portfolio size to 40 stocks. The Nomura Mid & Small Cap Growth Fund currently holds 71 stocks.
Arild Orgland, managing partner of the Norwegian wealth manager Industrifinans, believes Nomura’s conclusion that funds shouldn’t have more than 40 holdings, is rather rigid. “I believe diversification benefits diminish after reaching a certain number of stocks, but I can find quite a lot of funds with more than 100 stocks that have a high tracking error,” he says.
“I believe diversification benefits diminish after reaching a certain number of stocks, but I can find quite a lot of funds with more than 100 stocks that have a high tracking error,” - Arild Orgland
Orgland is referring to global equity funds here. Because their universe is much larger than that of regional equity funds, diminishing returns from diversification take longer to kick in. “For example, we own the Nordea Stable Global Equity Fund, which has more than 100 holdings and has had a very clear outperformance for a number of years,” he says.