Investors should diversify before their portfolios push them into a pauper’s grave.
The problem is, most investors think it’s perfectly acceptable to own fewer than five stocks, which is a preposterously small number for all but the most ardent of speculators.
To put some numbers on the issue, a recent survey of Germans explored their attitudes to investing in stocks. Some 56 per cent of the stock investors surveyed held fewer than five and roughly 86 per cent of non-investors thought they’d hold a similarly low number of stocks when they became investors.
But, to put it bluntly, nearly every investor should be far more diversified. It’s one reason why I like to follow portfolios of 10 or 20 Canadian stocks for The Globe and Mail while expecting investors to use them to supplement their already diversified portfolios.
The Canadian Free Cash portfolio can help to illustrate some of the benefits of diversification and the perils of concentration. In its original form, the 10-stock portfolio gained an average of 15.9 per cent annually over the 25 years through to the close of April 28, 2025.
In comparison, the overall Canadian stock market, as represented by the S&P/TSX Composite Index, climbed by an average of 6.8 per cent annually over the same period.
(The returns herein are based on backtests using Bloomberg data from the 28th of each month. The portfolios are equally weighted and rebalanced monthly. They include dividend reinvestment but not fund fees, taxes, commissions or other trading costs.)
The portfolio picks its stocks by starting with the largest 300 on the Toronto Stock Exchange by market capitalization. It then buys the 10 with the lowest, positive, enterprise value to free cash flow ratios (EV/FCF).
(As a brief reminder, enterprise value (EV) is equal to a company’s market capitalization plus its net debt. Free cash flow (FCF) is the amount of money a company can distribute to its shareholders while maintaining its operations. It is approximated by subtracting capital expenditures from operating cash flow.)
To demonstrate the potential pitfalls of holding only a few stocks, an extreme variant of the Free Cash portfolio was created that holds the single stock (of the largest 300 on the TSX) with the lowest EV/FCF each month. Its performance wasn’t nearly as good as the 10-stock version. The single-stock portfolio gained an average of 13.8 per cent annually over the 25-year period but it was more than three times as volatile as the 10-stock portfolio. It behaved sort of like a rocket that took off repeatedly only to crash and burn again and again.
The accompanying graph shows the performance of both portfolios in downturns with the one-stock portfolio faring particularly poorly.
For instance, the 10-stock portfolio’s worst decline over the 25-year period occurred in the financial crisis of 2008-09 when it fell 57 per cent from its prior high. On the other hand, the one-stock portfolio fell more dramatically on four occasions, with the worst showing being a crash of 78 per cent which started in 2017 that it has yet to fully recover from.
It seems unlikely that even the most masochistic of investors would have had the stomach to stick with the one-stock portfolio over the 25 years. It was simply too volatile despite beating the market over the full period.
Even the 10-stock portfolio is too concentrated for many people and I generally prefer to buy several baskets of stocks to build a more diverse portfolio.
It is important to add that it’s easy to buy very-diversified low-cost portfolios these days in the form of balanced exchange-traded funds (ETFs) like Vanguard’s Balanced ETF Portfolio (VBAL-T). Such funds can be used to form core positions, which might then be supplemented with individual stocks or baskets of them like the Free Cash portfolio.
When it comes to buying individual stocks, only risk what you can lose with equanimity.
Details on the Canadian Free Cash portfolio, and the other portfolios I follow for the Globe and Mail, can be found via a this link.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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