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How Much Diversification Should Your Portfolio Have?

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How Much Diversification Should Your Portfolio Have?

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.

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.

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.

Getting rid of stock-specific risk completely: is it possible using diversification?

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:

diversity-thin-portfolio

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.

Mutual Funds

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.

diversity-thin-portfolio-2

Final Word

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.

Others put the optimum range between 15 and 25.

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.

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Commodities

Latest Update On Oil – Expected to Settle Between $45 and…

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“Oil is going to a new price point because of the revolution in production,” said Bill Perkins, chief investment officer of energy-focused hedge fund firm Skylar Capital Management. Perkins believes the price of crude could fall as low as $45 a barrel. He is personally short, a bet that the price of the commodity will drop. He believes oil will settle between $45 and $80 a barrel in the next year.

“Companies are harnessing amazing new technology to destroy the traditional energy value chain,” Perkins said. “There’s a lot of money to be made on that.” “U.S. energy names remain a significant net exposure for equity long/short managers who added longs and cut shorts after October’s trough,” the report said. “If pressed, one could interpret this positioning as bullish for energy stocks.”

Andurand thinks crude might hit $50 a barrel within the half-moon of 2015 and so rebound to a high of $70 within the fourth quarter. He also said the oil market is oversupplied by between 1.5 and a couple of million barrels per day, given weak demand, low disruptions to produce and enhanced production by nations that do not belong to the Organization of the oil mercantilism Countries.

“OPEC is not the swing producer anymore. U.S. shale oil producers are, but will take more time to react to prices than OPEC—it is a game changer that will lead to more volatile prices and bigger price ranges,” he added.

Morgan Stanley aforesaid the worth would wish to fall as low as $35 or $40 a barrel to prevent production and rebalance provides.

Still, the bank noted that the worth can doubtless rise eventually.

“Oversupply is probably going exaggerated and therefore the market is also content regarding side risks,” the report aforesaid.

Read More at CNBC

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Commodities

Investing in Energy Markets Part 2: Oil, Gas and Energy

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It’s no secret that the energy industry is very profitable, with oil and gas making up 80% of the market.

 

Thus, these two resources attract the most people. They are the best energy investment resources due to high demand and wide range of options. However, with energy scares fresh in our recent memory and the climate change movement greatly affecting energy policy, new alternatives are constantly being sought.

Terror group ISIS may make $3 million a day selling oil

Everything that we do requires some type of energy. As a result, the price of energy affects the going rate for other commodities as well. When the price of oil increases, the price of transporting goods goes up as well.

That is why the cost of milk fluctuates and why your favorite imported coffee beans are more expensive than Folgers. Factors that contribute to these prices include geopolitics and natural disasters, but can never truly be accounted for in full. That is one of the underlying points to understand and accept about energy markets. Something can always go wrong. Typically, it doesn’t, but when it does things can get hairy and fast.

TYPES OF ENERGY SECTORS: That could affect your Household

Nuclear Nuclear power actually produces 1/10th of the world’s power, without emitting carbon. The United States and China have roughly 75% of the world’s nuclear plants with India and Russia also tapping into the market.

“Green” and renewable energy companies You can invest in different companies that place an emphasis on renewable resources by using the stock market. This option is optimal for investors who like the idea of green technology but do not now want to run the risk of investing in developing companies directly. This market has always been tricky from an investment perspective due to volatility. If you have an appetite for risk, however, this is a good place to look.

Modern Energy (solar, wind, geothermal, transportation, efficiency) Modern energy is made up of three major components or categories. They are wind, solar and biomass. The renewable sector is expanding at a rapid rate. We have witnessed a steady employment increase in the energy sector since 2011 with no end in sight. All types of investors and speculators are flocking to the natural resource markets in attempts to get out ahead of the renewable energy trend that could be the way of the future.

Big Oil In 2010, the world market for oil witnessed an incredible increase of 32%, to over $2,100 billion. According to estimations of oil segment professionals, the market’s value will hit $2,683 billion in 2015. The competitiveness of the global market of the crude oil is explained by its limited resources and mankind’s insatiable appetite for growth. This factor should not be disregarded easily. Our desire for more explains the majority of the energy marketplace.

Gas sector The market of natural gas reached $18.5 billion by the end of 2011. Demand for gas has recovered to match and surpass pre-recession levels. The US prices for gas are half of those in Asian countries and the EU. Gas demand decreased 3% in 2009, but at present is on the rise.

Electricity Buying the stock of electricity companies is the preferred way of entering this marketplace. The majority of the participation in electricity markets, however, takes place in the futures markets. Since power companies are constantly projecting and calibrating their loads, the futures market is the only place where investors with this sort of risk profile will feel that they belong.

Coal Many non-coal energy sectors directly depend on the performance of coal because burning coal has been proven to produce enough energy to support high demand. Due to recent regulations in the US by the Environmental Protection Agency, coal has taken a minor hit, but until a massive, institutionalized adoption of newer technology, it is highly unlikely coal will be going anywhere for the foreseeable future. In other words, coal is very much a barometer for this market. Though it is unlikely to happen any time soon, a massive dip in coal production would likely signal the emergence of a new viable energy source.

Hydro Hydropower energy is still very limited but there has been over $75 billion in investments pledged to R&D before the year 2020. There are some companies worth checking into, but for now this is very much a long term play.

Energy Funds These funds are established with companies related to the energy field. Be aware that some energy funds are more successful than others and produce a higher return than others. Often times, the energy funds are established to diversify various portfolios and minimize risk.

Read more on How Natural Resource Distribution affects your wealth

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Commodities

Oil Prices Surge As OPEC Members Agree To Cut Production

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The Organization of the Petroleum Exporting Countries (OPEC) took its first action in years to cut production on Wednesday in hopes of lifting oil prices. How big a cut did the cartel agree to? Will it really make a difference?

OPEC Members Agree To Cut Oil Production

Oil had its biggest day in more than five months as prices rose 5.3 percent. This action came after OPEC members agreed they could limit oil production – in November. While there are a lot of maybes, this is a big step forward for oil. But will it actually work?

While OPEC members agreed at a meeting Wednesday in Algeria that a production cut is needed to lift oil prices, plans for the supply cut won’t be finalized until November. Barrel output will go from 33.25 million barrels per day to 32.5-33 million barrels per day. A lot can go wrong between now and November, but for now investors love the news.

Many analysts, however, are not as optimistic.

This isn’t the first time this year OPEC has tried to cut oil supply. The committee met in April, but talks fell apart when Iran would not join the talks. In addition to that, all the OPEC countries compete against each other and the U.S. for market share. Several OPEC members, Iran, Libya, and Nigeria, all want to increase oil supply. Throw into the mix the political tensions of the group and this agreement seems very delicate.

Yet, there is a positive feeling about “this time”. Members are hoping that things are more conducive to getting a deal done. Many of the largest producers are close to maxing out capacity, so lowering output slightly wouldn’t be too much of a stretch. Additionally, Saudi Arabia and Iran are feeling pressure domestically from the drop in oil prices, and thus be willing to put aside differences to improve their finances.
Wonder why OPEC needs to cut production? Check the news here with CNNMoney!

For now, trading oil is a smart play. Exxon Mobil Corp. (XOM) rose 4.40% on the news. Chevron Corp. (CVX) rose 3.20%. Energy companies and oil shares will go up until november, and then take their cues based on that meeting.

The election is coming the Capitalist gives you the guide to thriving the election year markets. Read it all here!

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