Stock market portfolio diversification. Are you doing it wrong?

Are you diversifying your stock market portfolio all wrong? Diversification in theory provides a safety from your entire portfolio losing its value at the same time. You can think of it as not putting all your eggs into one basket.

For example, if you only bought one stock and that stock happened to lose half its value the next day, your portfolio will be 50% worse off. However, if you bought two stocks and that same stock lost half its value, your portfolio will only be down 25%.

The more stocks you add, you expose your portfolio to less risk from individual companies. That in theory is why diversification is important. But, here in lies the question. How much is too much diversification and have you been doing it wrong?

How much is too much diversification

With investing, that depends. It depends on you as an individual and what it is you are trying to achieve as an investor. Benjamin Graham, the father of value investing put this number between 10 and 30.

A study completed by Frank Reilly and Keith Brown found that portfolios should hold a range of 12-18 stocks. This amount would provide 90% maximum benefit of diversification. Any more will just diminish the effects of diversifying your portfolio.

But that’s not to say that holding 30 companies is also wrong. Every investors risk tolerance and time horizon is different. But if you would feel safer to invest in more companies a better option might be to invest into index tracking funds.

Index tracking funds will provide you guaranteed diversification, as you are essentially buying the market. Instead of buying 30 individual stocks, you can just hold 1 index exchange traded fund.

What does diversification really mean

There is a misconception of what diversification really is. Buying stocks in 10-20 companies does not equate to diversification if these companies are all within the same sector.

Take investor A and investor B as an example. Investor A bought stocks in 20 separate businesses, whereas investor B bought stocks in 5 separate businesses. Just from this information alone, you may conclude that investor A is more diversified than investor B.

However, what if I was to tell you that while investing in 20 separate companies investor A purchased 15 companies in the consumer discretionary sector and 5 in financials.

Whereas, investor B bought shares in companies in 5 separate sectors (i.e consumer staple, financials, software, energy, materials etc.)

Investor B while having invested in less companies is by definition, more diversified than investor A. You should not mistake diversification for the quantity of stock that makes up your portfolio. But how much the companies differ from one another.

While diversification can protect your portfolio from market volatility, it does not protect you from systemic risk. Systemic risk is the breakdown of the entire stock market and not just an individual company.

Diversification can lead to diworsification

If you haven’t already read Peter Lynch’s: One Up On Wall Street, it is a book worth reading. In this book, he coins the term “diworsification”. Diversifying for the sake of diversification is nonsensical.

Peter Lynch initially used diworsification to explain companies that expanded into areas outside their core business. Because these business started exploring outside their area of competence, it ultimately led to their demise.

Translating this into stock market portfolio construction, diworsification is the result of adding far more stocks in your portfolio than is required. Resulting in increased unnecessary risk without the benefits of higher returns.

That is why over diversification comes with a cost. It reverts any chance of large potential upside or downside back to the mean. The mean being the average stock market return. Which in this case, investing an exchange traded fund that tracks the ASX300 (S&P500 in US) might be a far simpler option.

Takeaway

• Diversification is necessary to minimise portfolio volatility the stock market
• How many companies you hold in your portfolio depends on your risk tolerance, time horizon, investment goals etc. There is no one right answer
• Over diversification can lead to diworsification, exposing your portfolio to unnecessary risk without higher returns
• Systemic risk cannot be diversified away

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