The concept of diversifying is relatively simple, the execution is a little trickier. In this article, we will run through some of the important things you should know about if you want to incorporate diversification into your portfolio effectively.
Right off the bat, investors should know that diversification offers a great way for them to reduce the risk they face without lowering their expected returns.
People have, in fact, long known of this theory, we have been saying it for centuries – “Don’t put all your eggs in one basket”. However, wrongly implementing this can render this important strategy inconsequential or even costly to portfolios.
Why Investors Should Diversify Their Portfolios
As mentioned above, diversification offers investors a way to limit the risks their investment portfolio is exposed to without reducing their overall returns. By adding more stocks into their portfolio, investors are able to reduce the unsystemic risks they are facing. Unsystematic risk, also known as specific risk, can be reduced through proper diversification.
Unsystemic risk affects single companies, sectors, countries and regions. To give you a picture of what this entails, here are some examples – for single companies, this may include a company going into insolvency because of cashflow problems; for sectors, this may include the companies in the property sector suffering after a hike in interest rates or new government policies; for countries and regions, this may include a natural disaster affecting companies in certain geographic areas.
Diversification works because investors would not lose all of their investments in the event that one company in their portfolios is adversely affected.
Doing this does not mean you are shielded from losses. This is because investors will still be exposed to systemic risks. This is the risk that an investor has to bear no matter what he or she does or invest in as it usually has an impact on the global economy and affects most, if not all, financial products.
How Many Stocks Should I Hold In My Portfolio?
The most important thing to note about diversification is that it needs to be done properly. Otherwise your efforts would be inconsequential and you may even affect your portfolio negatively.
While there is no rule for the optimal number of stocks to own. Many research literature suggests a number between 20-30. Some however, have even put forward owning as little as 15 or as many as 50 stocks as the optimal holdings.
Another way to think about an optimal number of stocks in a portfolio is that we should not own too many. If we consider that an investor with an equal investment in 100 stocks, and that his portfolio gives him a dividend of 3% per annum, to achieve a 7% return, the investor would need four of his stocks to double in value.
Instead, if we consider an investor holding 20 stocks, also giving him a dividend of 3%, to achieve the same 7% return, the investor would only require one of his stock to increase in value by 80%.
We’re not saying that stocks should be increasing in value by 100% or even 80%, rather this is just a simple way to highlight that beyond a certain point, quality should matter a lot more than quantity.
For us at DollarsAndSense, we think this number should be close to 20 stocks. This is because there is good research backing this number, it is not too many that it confuses or weighs down on investors. Neither does it costs investors hefty transactional fee
Should You Just Buy Any 20 Stocks?
The answer to this rhetorical question is, in fact, no.
To diversify optimally, investors have to invest in a pool of stocks that are negatively correlated. In our above example, we detailed that some problems that may arise for companies include cashflow problems, a situation where interest rates go up, or natural disasters.
Using these three examples again, we highlight what investors have to consider when they go about choosing their 20 stocks.
For the example of a single company facing cashflow problems, investors should also note if this company has other listed subsidiaries that you may have invested in that could be similarly affected, or whether they are large customer of another listed company whose cashflow could also be similarly affected.
For the example of a rise in interest rates, investors should not have been concentrating their portfolios in 10 different REITs (Real Estate Investment Trusts). This would mean half their portfolio being affected by this one specific event.
For the example of a natural disaster, investing in a few companies that are only operating in certain parts of Indonesia or Japan may cause your portfolio to be heavily impacted by a single natural disaster, should it unfortunately strike that country.
In other words, while diversification is a good strategy, it needs to be done right for investors to reap its benefit.
Your Diversification Strategy
To summarize, investors should take note of the following points when embarking on their diversification strategy.
– A good number to aim toward to have in your portfolio is roughly 20 stocks
– Investing too little of your entire portfolio into one stock will not have a meaningful impact on your overall strategy; ie investing 1% or less.
– Using our aim of 20 stocks, we should also avoid investing more than 10% of our overall portfolio in a single stock.
– For optimal diversification, we should avoid concentrating our investments in companies that
- have the ability to significantly affect one another, either because they are related companies or are big suppliers or customers.
- are in similar industries.
- only operate in a single country or region.
What are some other areas of diversification that should be considered? Discussed your thoughts with us on Facebook.
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