How much diversification is enough?
Many ask what does diversifying my portfolio means? How do I do this? Well first, in simple terms, Diversification is spreading your money out between different investments. Imagine you had $1,000 to start investing and you took 1 whole year to build that money up, so you could open an account to start buying stocks. You invest that $1,000 in ABC company, and a week later after you bought $1,000 worth of stock in ABC Company, the company announces they are filing for bankruptcy. You watch your $1,000 worth of stock drop in value to $75. You put all your eggs in one basket, hoping that ABC Company was the winner and you had all the faith in the world in it. You just saved up for 1 whole year to invest in 1 company. This is exactly the opposite of diversification. And as I stated before, you put all your eggs in one basket. Well much like life and what your parents have always told you, this saying is similar for investing. DO NOT PUT ALL YOUR EGGS IN ONE BASKET. Do not put all your investable money into 1 position.
Diversification is a term and strategy used in investing to ultimately reduce your risk. If you were to spread your $1,000 of investable money into 15 different stocks, asset classes, sectors, ETFs, Mutual Funds. Doing so, reduces your risk. Do you see? If you don’t depend on one investment to make all your money, then you are diversified. This is one of the first and main topics taught to all students at the University and College level who are interested in a career in finance. It is simple to understand but can also become more complex when you really dive into diversifying throughout all the many different investment options that the stock market has to offer.
Imagine if one large event were to happen. Think politically, natural disaster, or some life changing event. You want to be invested in different areas where some of your investments won’t be influenced to drop in value because of that event. You will be touched in some way, shape or form in your portfolio, but the key is to have some gains that can offset the losses.
At what point do you reach a fully diversified portfolio?
In theory, diversification is about buying investments act differently in different market environments. Diversification is all about exposure, what is exposed to what?
Through all the studies that have taken place over time regarding how diversified in diversified enough… Many tend to say the amount should be between 20 to 40 investments. On the contrary, many investors will say a more concentrated portfolio, which means just a smaller amount of investments, typically 5-10 positions, will drive the portfolio to outperform. This may be true, and in these cases usually the fundamental research is very strong behind these portfolios. Meaning that the investor knows their stuff. They have a significant reason for each individual investment and know the ups and downs it may bring. Obviously, they see more upside potential if they are including it in their concentrated portfolio of 5-10 investments. This is taking on more risk than what investors would call a “diversified portfolio” of 20-40 investments.
Concentrated portfolios are also known as “more aggressive.” This means the portfolio manager or investor is highly confident that their smaller amount of investments will outperform the market itself. Now as a beginner investor, sticking with a diversified portfolio is probably your better option. You want to limit the aggression and focus more on the long term. That is key for diversified portfolios, build your investments over time compared to the shorter-term aggressive portfolios that are aiming to outperform the market in the near future.
Taking on Risk
It is all about Risk. How much risk do you want to take? Are you really that confident in 1, 2, 5, 8 investments to make you money? Or would you rather spread your hard-earned money through 20, 30, 40 investments and watch it grow over time?
Imagine you were only going to invest in stocks. To diversify you would want to spread out your money between the different sectors. One key point to remember, is also factor in the size of the companies. Research has shown that investing in the same industry heavier than other industries, can work. But you want to consider the company size for this type of situation. Maybe take the 2 largest companies in that sector and then also 5 of the smallest companies. This is still true for when you invest in different sectors. You don’t have to choose the 3 largest companies in each sector. Maybe pick some large technology companies and then pick some smaller energy companies. It almost is just about being all over the place. But when I say being all over the place, there is research driven behind that and facts.
Do your research about the companies, sectors, how a possible current even can affect a particular company, historical trends and events of a company. Know your stuff, investing is tricky, but with the right research, due diligence, and timing, you may just pick a winner! ff