One of the most important keys to successful investing is to manage your risk. One way to do that is through diversification, and although many people have heard of it, most don’t put it into practice.
Why not?
It’s usually because most investors don’t truly understand its importance, don’t understand how to do it correctly or don’t have the discipline to implement a well-diversified portfolio.
So just how many stocks do you need in order to create a properly diversified portfolio?
That’s a question that has been debated since at least the 1950s and, even today, continues to be a major source of controversy among the financial elite.
Benjamin Graham, Warren Buffett’s mentor, argued that as few as 10 well-chosen stocks could accomplish the task. Buffett has also argued for 10 or fewer well-chosen stocks. However, today, most experts recommend holding between 20 and 30 stocks.
But regardless of the actual number of stocks you decide to hold, the key is they must be, “well-chosen.” Selecting 30 or 100 or even 1000 stocks that behave the same way because they are in the same industry or are affected by the same external shocks is not proper diversification. At best this type of “diversification” shields you from a single company going bust, but it does very little to protect your portfolio from the wild swings in portfolio value due to stock market volatility.
Well-chosen stocks need to behave differently over long periods of time. There is no perfect way to select which stocks to hold, but there are methods you can use to increase the probability your portfolio will be properly diversified.
Select Stocks with the Lowest Correlations
One easy way is to choose stocks from different industries that behave differently. But perhaps the best method is to calculate the correlations between stocks for a 5 year period and select those stocks with the lowest correlations between them. This is simply a mathematical way to select stocks that behave differently – so when one is going up, another is going down and vice versa.
However diversification is a two-edged sword. While it’s important to protect your portfolio, it also dilutes the impact of any one stock’s effect on your portfolio. In other words, the more stocks you hold, the less any one of them will affect your overall holdings. If you only select great stocks, this shouldn’t be much of an issue, however if you’re like most investors and select less-than-stellar companies, you will be diluting the effects of the few excellent stocks you hold.
In fact, if you pick too many stocks, your returns will start to approach those of an index fund. This begs the question: if you’re going to receive index fund-like returns, why go through the trouble of selecting and managing hundreds of stocks in the first place? Simply buy an inexpensive index fund and be done with it.
And of course with more stocks come increased costs – in trading costs, short-term taxes, time and effort.
How to Diversify When You’re Just Starting Out
And many investors who are just starting out don’t have enough money to purchase even 3 or 4 different stocks, let alone 10 or 20.
One way around this is to take advantage of the stock purchase plans offered by some companies. These plans allow you to purchase a small number of shares (sometimes as little as one share) and then purchase more each month.
Dividend reinvestment plans also let you accumulate more shares in a company by reinvesting any dividends generated by your current shares.
Using these two options can allow you to diversify right from the start, even if you’re starting out with a modest initial investment.
As for me, I tend to agree with Buffett. If you are choosing great stocks, you should need no more than 10 well-chosen stocks to be properly diversified. If, on the other hand, you select your stocks by listening to hot tips or believing what you hear on television, then you’d better diversify widely.
It’s important to remember, however, that diversification is just one tool in your investment arsenal and needs to be combined with other tools, such as stock selection, allocation, sound money management and rebalancing, in order to truly get the most out of your investments.
