Principles of Stock Diversification
Diversification is a practice that investors use to reduce risk and maximize returns by investing in various industries that will most likely react differently to the same event in the market. When investing, there are two types of risk that investors face:
Undiversifiable— Also known as systematic or market risk, this is risk that all companies are exposed to and includes inflation, interest rates, exchange rates, political instability, etc. This risk is just the price of doing business, as all investors must assume it.
Diversifiable— Also known as unsystematic risk, this is risk that can be specific to a company, industry, market, or country. Diversification can help manage and reduce this risk.
How to Diversify
Most experts agree that diversification is extremely important to reaching long-term goals while mitigating risk. A properly diversified equity portfolio should hold stocks from different industries, company sizes, valuations, growth rates, and countries to help reduce volatility and limit exposure to a permanent loss of capital. The more uncorrelated the stocks in your portfolio are, the more you are limiting your risk exposure. Let’s say you have a portfolio of only automotive stocks and it appears there will be a strike. Most likely, all of the automotive stocks will experience some drop in their share prices, and in turn, you will see a noticeable drop in value. However, if you have stocks in other industries that are performing well, you will be able to offset some of that loss and mental anguish that goes along with it.
How Many Stocks Should You Own?
While there is always debate about how many stocks to own in a well-diversified portfolio, most experts agree that 15 to 20 stocks across different industries is optimal. This portfolio size is manageable, yet it allows you some room for losses. The other extreme is overdiversification where investors hold too many stocks, which makes it almost impossible to know the companies well. Not being knowledgeable about your stock investments can lead to making irrational decisions, which will negatively impact your portfolio returns. The key is to strike an appropriate balance. Another impact of overdiversification is that an investor can become indifferent regarding his/her investment decisions. If you’re holding over 100 stocks, any individual stock might represent only a small percentage of the total portfolio. If the stock turns out to be a loser, it won’t cost you very much; but if it provides great returns, you won’t reap the benefits either. Diversifying your stock portfolio will help you manage the risk of the price movements of your assets, but it can’t completely eliminate risk and volatility.
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