Everyone knows that you need to have a diverse portfolio to lessen the risk that comes with investing in anything nowadays, be it equities, securities or bonds.
No one wants to put all their eggs in one basket, see that basket crumble, and the eggs break.
But similarly, you don’t want to spread yourself so thin that you find you can’t keep track of those eggs.
Read on for more information.
First, diversification explained
When managing a particular investment portfolio, whether down by a designated asset manager for a client, or an older worker working with their financial advisor to prepare their retirement fund, the decision maker attempts to less the funds exposure to market risk.
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This is done by investing in a variety of companies in different industries.
You can go even further by investing in different countries.
The idea is that if one industry fares badly, the investment portfolio is protected from the bulk of the downfall as, say, only a fifth of its funds are enshrined in that particular industry.
Repeat the point for country, sector, company, and repeat ad nausea.
While no guarantee against loss, investment honchos agree it is a wise strategy to at least lessen losses and move closer to long-term financial aims.
Studies prove this common sense to be true.
It works because industries don’t correlate with each other a lot of the time.
- The health of the VR video game industry will move in entirely different cycles and peaks and troughs than, say, the pharmaceuticals industry.
- While both might run down to a third factor, say a recession in their wider economic environment, they don’t have a causal relationship with teaching other.
- In this way, bar some horrible bad luck (which does happen, believe) not all of your invested industries will see falls at the same time, bar a recession.
A portfolio performs better if it abides by this apparently logical reasoning.
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Having said all this, one must remember that risk can never be eliminated even if your portfolio has the most prudent and intelligent diversification done by the world’s best investment brainiacs.
Unsystematic risk (risk to individual stocks) can be reduced, but the general market, or systematic risks, will always be there, and no spreading of your eggs will stop that.
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Volatility is a widely used barometer of how risky a stock is.
If it is experiencing massive peaks and troughs always, it means that it is, of course, a risky investment as there’s a decent chance it will lose or gain value compared to what you pay for it initially.
Just as a bit of a lot of money is a high risk, as the potential loss is great, as is the potential gain.
Standard deviation is a word used to describe, in all essences, the risk associated with a stock, when looking at its numbers in a statistical way.
The graph below demonstrates this visually:
The highest risk is to the beginning of the chart, where there is a moderate amount of diversification, and it decreases sharply moving to the right before evening out and become a very gradual incline.
This particular graph shows optimal diversity in a portfolio to be around 20 different stocks.
This is a reasonably accepted number amongst many traders and finance eggheads, though you will undoubtedly find some arguing for lower or higher numbers.
The bible of stock market capitalism, ‘Contemporary Portfolio Theory’, was published in 1981 and was written by the economists Edwin Elton and Martin Gruber.
Through rigorous data analysis they concluded that your average portfolio with no diversity, so a single-stock portfolio:
– Carried a risk of 49.2%
– After broad diversification, risk was reduced by 19.2%
– At 20, risk was 20%
So they found that increasing numbers of stocks in the average well-constructed portfolio worked to decrease the chance to a figure of 19.2%, which many accept as a standard market risk.
Their research agrees with the previous graph, in that the benefits of moving past 20 were not that valuable regarding reducing risk.
At 20 stocks, they saw the risk of around 20%.
With their upper end of stocks in a portfolio at 1,000, this means that those 980 extra stocks reduced the risk by only 0.8%, whereas the first 20 reduced it by over 29%.
This magic 20 number could be the number of isolated spots there are in the wider market that is isolated enough from each other, or it could correspond to the number of clearly definable industries in which you could invest.
Which flies in the face of the mantra of constantly diversifying for reduced risk.
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Diversification is more than about numbers: specificity over quantity
It’s clear that it is not just about getting 20 stocks and hoping for the best.
The idea is get stocks with a wide variety, having variations of market capitalization, industry, country, type of company, employee size, profitability and any other metrics used to define companies.
No correlation is the aim of the game.
Buy stocks in companies that have no relation to each other.
Not to mention looking outside stocks for your portfolio, to things like bonds and securities.
Remember that these can tend to be sector-specific, as they are often marketed to those optimistic about an individual industry.
If the industry is going swimmingly, the fund will gain, but the risk is significant as the stocks will all fall if the industry falters.
Look for balance, rather than sector-specific funds.
Also, because mutual funds are continually managed, they can tend to be over-diversified, meaning that there are hundreds of stocks.
This can work to prevent the fund outperforming indexes, which was the very reason you invested and paid the management fee to start.
There is another thing to remember about mutual funds and diversified stocks in general.
What many investors won’t tell you is that a hugely diversified fund works best when you don’t need it that much, in a growing industry, and worst when you desperately need it, in a falling one.
The following graph shows how a commodities-focused diversified stock wouldn’t have been successful, with oil falling far behind stocks and agriculture, but then picking up faster than agriculture did.
So, to conclude, the common wisdom is that 20 stocks is a good number to have, and it diversifies to reduce risk without unnecessary ballooning of the funds size and complexity.
Additional shares prevent outperformers impacting the bottom line, a danger with massive mutual funds of several hundred stocks.
Buffett famously quipped that broad diversification was only for those who didn’t understand what they were doing, and thus needed the false sense of security that was offered by investing in hundreds of stocks, rather than a few dozen well-placed ones.