This post is a simple introduction to diversification, geared towards stocks.
Portfolio Investment Diversification – Diversification vs. Asset Allocation
Diversification and asset allocation are often confused with one another. Think of asset allocation as selecting the percentage of stocks and bonds you want to have in your portfolio. If you’re invested in a single stock and a single corporate bond, your asset allocation would be 50% stocks and 50% bonds.
Diversification is choosing which stocks and bonds to invest in. In the above example, you would not be considered diversified because your holdings consist of only one stock and one bond.
There are two parts of diversification. First, you need to be diversified between assets sectors. For example, if you owned only stock in Wal-Mart, your entire portfolio is in the retail sector. To diversify your portfolio between asset sectors, you would need to add a stock outside the retail sector. An option could be to purchase stock in Google, which is in the technology sector.
Part two consists of diversifying within each sector. Continuing with the previous example, you could add other retail and technology stocks. Therefore, you might add Target and Best Buy stock to spread your risk in the retail sector and Microsoft and Yahoo stock to spread your risk in the technology sector.
When Are Investments Diversified?
The next question any investor must ask is how many stocks and bonds must they own in order to be diversified? Research was done 30-40 years ago proved that you only need to have about 15-20 stocks to be diversified. More recently, researchers found out that 15-20 stocks only capture about 75% of the diversification that you would need. Not even a portfolio of 60 stocks would represent 100% of the market. Portfolio diversification PDF download.
Managing a portfolio of 15-20 stocks isn’t cheap for the individual investor. Now, imagine managing OVER 60 stocks to get proper diversification.
Warren Buffett on Diversified Investments
In 2006, MBA students from the University of Florida were lucky enough to have a lecture by Warren Buffett. In the Q&A section, one student asked about diversification and here was his response (around the 1 minute mark)
I believe in extreme diversification. I believe that 98 or 99 percent, maybe more than 99 percent, of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all, that is the way they should approach it.” – Warren Buffett
Don’t make portfolio diversification a harder concept than it has to be. A portfolio of index funds that match your risk tolerance will be all the investment diversification you need.
Photo by: Art Comments