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Diversification

Posted By Robert On Sunday, January 26th, 2014 With 0 Comments

You’ve likely heard the phrase ‘Don’t put all you eggs in one basket’. Well, some of the oldest clichés carry the most truth.

In this section, you’ll…

  • Learn what diversification is and why it’s an effective risk-reducing strategy
  • Understand how diversification differs from asset allocation
  • Learn three methods to properly diversify your portfolio

At its simplest, risk is really just a measure of possibility of either losing value or not gaining value. In investment terms, risk is the uncertainty that an investment will deliver its expected return.

Diversification is the further division of asset categories into specific investments, to reduce the overall risk to your portfolio in case one or more of your single investments decrease.

The following illustration depicts graphically the concept of diversification and how it differs from asset allocation.

Asset AllocationWith the funds you have available to invest…

“…determine what percentage should be divided into stocks, bonds, and cash equivalents…

…then further divide each asset category by type, size and geographical origin to achieve proper diversification.”

It is important to appreciate that diversification does not eliminate risk. It is merely a tool that can reduce the risk you face with your investments.

The number one rule to protect yourself against having a losing stock is this: Don’t put all, or even a great deal, of the money you have designated for the stock market into a single stock! The reason is that nobody – and we mean nobody – can predict with certainty that any one particular stock won’t fall.

Ensuring stocks are not all highly correlated is important to ensure that market developments impacting one particular sector don’t adversely affect the whole portfolio. For example, if you only hold banking stocks then adverse news affecting the banking industry would impact the entire portfolio.

The More You Diversify, the Better

Bad things happen to good people. And even the best of stocks can run into hard times.

For long-term stock market success, you need to hold a number of stocks. It’s the best protection against fallout from any one individual stock plummeting. The more stocks you have (up to a point – which we’ll expand on in a moment) the less damage any one imploding stock can do.

How Much Does Diversification Help?

Suppose you invested in what you thought was a winning stock. But instead of rising, the stock price plummeted by 90 percent. Take a look at the summary below to see the damage that would be done to your portfolio’s value if the stock accounted for 100 percent, 50 percent, 25 percent, and 10 percent of your portfolio’s value.

Suppose your total capital is $10,000
If stock amounted to 100% of your portfolio your loss would be 90% of your capital.
If stock amounted to 50% of your portfolio your loss would be 45% of your capital.
If stock amount to 25% of your portfolio your loss would be 22.5% of your capital.
If stock amount to 10% of your portfolio your loss would be 9% of your capital.

How Much Does Diversification Help?

As you can see, the lower the plummeting stock’s percent importance within the total portfolio, the less impact it has on the portfolio’s overall value. This is a simple, yet powerful example of the importance diversification plays in protecting the value of your investment.

Beta is a measure of a stock’s risk in relation to the market.

But just how much diversification do you need?

I got a mail in recently from one of the readers of the blog asking about market correlations between different stocks, particularly those in the same same sector (e.g. the UK banks) so I thought I’d do a post touching on some of the things to look out for in this area. In particular in this post I’ve decided to focus on diversification and what it means to the investor. Later, I’ll discuss some other correlations between different types of markets, such as the relationships between the major stock markets, currencies, interest rates and commodities, but for now let’s just look at creating a diversified investment portfolio.

One of the main subjects that many professional investors (those that write books and talk at seminars and the like…) talk about is diversification. Often referred to as the one and only true ‘free lunch’ available to investors, I have no doubt there are many benefits to having a diversified portfolio. For me however the big thing is making sure it is actually diversified. Lets look at a couple of different examples of diversification.

All Your Eggs In One Industry Won’t Work

I’ll start by talking a bit about the share price correlations, in particular stocks in the same sectors or industries. If you have 10 grand to invest and you decide to put 2K each into BoI, AIB, Citibank, Bank of America and HSBC for example, on the basis that you think the financials have taken too much of a battering over the last 12 months and are ripe for a rebound… Well this really isn’t diversification in my book, your call may well be right and most or all five of your picks will rise, but you could just as easily be wrong and the market decides that there are still more write downs, more bailouts, more nationalisations, etc to come from the financials globally, in this case you can bet all five of your investments are going to tank to varying degrees. The above approach might offer some minor benefits in that it would be unlikely for all five stocks to go bust or be nationalised (although anything is possible these days!).

Diversified Stock Portfolio Is Better But Still Not Great

So if you want to avail of diversification then a second approach would be to put 2K into 5 stocks from different sectors, for example 2K into Bank of America (for some financial exposure), 2K into Apple (for some technology exposure), 2K into BP (for some oil / energy exposure), 2K into CRH (for some construction exposure) and 2K into GlaxoSmithKline (for some pharma exposure). This approach will at least reduce the likelihood of all of your five investments getting hit at the same time and to the same extent. But again it’s not a guaranteed approach and would have provided little respite to investors over the last 12 to 18 months when global stock markets tanked and almost no sectors avoided the sell-off the occurred.

True Diversification Looks Beyond Equities

That brings us to approach number three, true diversification, this can only be achieved by looking beyond just equity investments. Let’s say our notional investor decided to invest his 10K as follows: 2K in an ETF (Exchange Traded Fund) of their choice to get some equity exposure (diversified equity exposure at that!), 2K into a property portfolio or fund (it would be hard to get any real property exposure for 2K but you could invest in a property focused stock like British Land or Blackrock International), 2K into commodities (lets say gold or oil), 2K into a Government bond (US Government bonds currently pay approx 4% interest) and keep the final 2K in cash. This approach provides true diversification and makes for the safest way to not completely lost all your investment. In the above example you’d be very unlucky to lose more than 50% of your investment (assuming governments continue to honor their bonds, gold/oil doesn’t go to zero any day soon and cash remains king!).

The downside to this final example of ‘true diversification’ is of course the return you’ll get. The price you pay for the added security your portfolio gains by diversifying is typically a lower rate of return compared to the investor who decides for example to put all their money into high tech stocks. Although the diversified investor probably found it much easier to sleep at night over the last year! This trade-off really depends on your personal circumstances and your appetite for risk. One thing is for sure, any investor who doesn’t deploy some level of diversification (even if it is only the first approach discussed above) to their portfolio is asking for trouble!

How Many Stocks You Should Own: An Easy Rule-of-Thumb Explained

Obviously, you need to have more than a couple of stocks to properly diversify your investment portfolio. Otherwise, if one stock went to zero, it could halve your savings overnight.

On the other hand, there is no point in holding dozens and dozens of different stocks. It’s hard to research too many companies, decide when and how many shares to buy, and keep an eye on their progress. In addition, you’ll end up paying a lot more in commissions, and may even end up with some overlap.

How Many Stocks You Should Own: An Easy Rule-of-Thumb Explained

Thankfully, a lot of smart math-types have crunched the numbers and found that as you increase the number of stocks in your portfolio, the risk level drops dramatically. But beyond about twenty stocks though, your portfolio’s risk eventually stabilizes.

So a good rule of thumb is this: Have a minimum of around 12 stocks, and a maximum of around 20.

Make the Most of Your Money: Spread It Around

There’s more to diversification than, well, having more stocks. You should also consider spreading the money you plan to invest in stocks around in three other ways:

  • Diversify by type of company
  • Diversify by size of company
  • Diversify by location of company

Diversification by Type of Company:

If you put your money into a number of different high-tech companies, you’ve taken the first step toward diversification. If one company suddenly smacks into a financial wall, you will likely come out with only a few scrapes and bruises. If that company’s stock plummets, it will pull down your portfolio. But hopefully your other stocks will do well and offset the damage. In the best case, your portfolio may even come out on top due to the strength of these other companies.

But what if the company that took a dive was the most successful in the industry? Investors may decide that if the leader’s prospects have suddenly turned dismal, bad news will likely hit other high-tech companies. Across-the-board bailing out of high-tech stocks may ensue. And with all your money in high-tech stocks, your portfolio could end up under water in a big way.

Entire sectors of the economy can, and regularly do, run into downturns. And this can happen when other parts of the economy are doing great. Gold stocks, for instance may be rising but stocks of companies in the retail sector may be falling. The stocks of banks and other financial companies may be having a bad time, but pharmaceutical stocks may be zooming up.

Given that it’s tough to know which sector is set to soar and which is ready for a setback, you should spread your money around between a number of different sectors.

Entire sectors of the economy can, and regularly do, run into down turns. Spread your money around a number of different sectors.  Stock picking-selecting a single successful equity is incredibly difficult.

Diversification by Size of Company

Size matters! The bigger a company is, the more stable and safe it tends to be. The larger a company, the wider the range of products and services it sells, and the greater its number of customers. This means the company’s future doesn’t rest on any one product or customer.

Bigger companies also have deep pockets. They have the financial strength to weather downturns. They also have plenty of people looking further into the future, developing products and new services that will help ensure the company’s growth remains strong.

If you are just starting out building a stock portfolio, sticking to the larger companies within an industry is wise. Here’s why:

  1. You’ll know you’re buying into companies with proven demand for what they sell.
  2. They have long histories that let you assess their performance over many years.
  3. Their stocks tend to weather economic and stock market storms better than those of smaller companies and businesses just starting out.

When it comes to diversifying by a company’s size, it’s important to first understand how companies are sized in the stock market. We’ll cover Investing In A Company Size in more detail in the next lesson.

Bigger companies tend to be less risky than smaller companies.  If you are just starting out building a stock portfolio, sticking to the larger companies within an industry is wise.

Diversify by Geography

While the U.S. is the world’s greatest economic engine, there are thousands of stocks that are traded everyday around the world at other stock exchanges.

In England and Tokyo for example, there are two major stock market exchanges – the London Stock Exchange and the Tokyo Stock Exchange respectively.

But in addition to England and Japan, there is an entire world of investing possibilities. Europe, Canada and Australia all offer attractive ways to diversify and invest in big and small companies outside of the U.S.

Because these markets often move in different directions than the U.S. markets, they can reduce the volatility of your portfolio. Also, there are many exciting high-growth companies outside the U.S.

International stocks offer attractive ways to reduce the volatility of your portfolio.

To diversify further, you can look at emerging markets. These are the stock market equivalent of small-cap stocks. Emerging markets such as Latin America, India and China are highly volatile. However, it can make sense to have a small portion of your portfolio invested in emerging markets because when they take off, they can soar.

Key Learning Points

  • Asset allocation is one effective risk-reducing strategy to protect your investments and increase potential returns, diversification is the other.
  • Diversification is the method of further dividing up your investments within a specific asset class. With the asset class of stocks for example, diversification would entail spreading your investment across different types and sizes of companies, in different industries and in different countries.
  • The best way to deal with the unpredictability of individual stocks is to buy a wide variety of them. A well-diversified portfolio consists of at least 12 stocks but no more than 20.
  • It’s wise to concentrate on large, proven companies when investing in stocks. Smaller companies offer potentially higher returns, but also higher risk.
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