We’ve all heard about the benefits of diversification in a portfolio. A personal stock portfolio must be diversified to some degree as none of us wishes to “put all our eggs in one basket” and expose ourselves to the inherent risk of holding only one stock which may move up and down in price hence affecting our values significantly. But can you go too far in spreading your risk? At times there is such thing as having your portfolio over-diversified.
Diversification refers to investing in various companies across different sectors, industries or even countries in an effort to minimise risk. Most investors agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt towards your long-range financial objectives. Put simply, by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility by the fact that usually not all industries and sectors move up and down at the same time or at the same rate. This provides for a more consistent overall portfolio performance.
It’s important to remember that no matter how diversified your portfolio is, your risk can never be shrunk down to zero. You can reduce risk associated with individual stocks (unsystematic risk), but there are inherent market risks (systematic risk) that affect nearly every stock. No amount of diversification can prevent that. So many stocks should you own to be diversified but not over-diversified? It seems sensible to own five stocks rather than just one, but at what point does adding more stock to your portfolio cease to eliminate market risk and in fact work against your overall returns.
The generally accepted way to measure risk is by looking at volatility levels. That is, the more sharply a stock or portfolio moves within a period of time, the riskier that asset is. Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn’t be farther from the truth. There is strong evidence that you can only reduce your risk to a certain point at which there is no further benefit from diversification. If we look at performance of the market this year, you were actually better off picking a select number of stocks rather than diversifying across the entire market. Even with the number of shares you choose to diversify in, higher weighting (allocation of funds) should be given to the stocks that are expected to outperform.
Diversification is definitely a prudent strategy but like any good thing too much of it is not good. There is no common consensus as to how many stocks you should own to have a well balanced portfolio. This depends on personal risk profile as a person with higher tolerance to risk will probably be less diversified than a person with a lower tolerance to risk. In all cases it must be remembered that owning additional stocks takes away the potential of big gainers significantly impacting your bottom line. Warren Buffett once quoted “wide diversification is only required when investors do not understand what they are doing”.
Published in the Business Daily – Waceke Nduati Omanga