We've all heard the financial experts expound on the benefits of diversification, and it's not just talk; a personal stock portfolio must be diversified to some degree lessen the inherent risk of holding only one or one kind of stock.
But here we'll show you how investors also tend to become overdiversified and how you can maintain an appropriate balance.
What Is Diversification?
When we talk about diversification in a stock portfolio, we're referring to the attempt by the investor to reduce exposure to risk by investing in various companies across different sectors, industries or even countries.
Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works, but to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.
This is because different industries and sectors don't move up and down at the same time or at the same rate - if you mix things up in your portfolio, you're less likely to experience major drops, because when some sectors experience tough times, others may be thriving. This provides for a more consistent overall portfolio performance. (For background reading, see The Importance of Diversification.)
That said, it's important to remember that no matter how diversified your portfolio is, your risk can never be eliminated. You can reduce risk associated with individual stocks (what academics call unsystematic risk), but there are inherent market risks (systematic risk) that affect nearly every stock. No amount of diversification can prevent that.
Can We Diversify Away Unsystematic Risk?
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. A statistical concept called standard deviation is used to measure volatility. So, for the sake of this article you can think of standard deviation as meaning "risk".
According to the modern portfolio theory, you'd come very close to achieving optimal diversity after adding about the 20th stock to your portfolio.
In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis", they concluded that the average standard deviation (risk) of a single stock portfolio was 49.2%, while increasing the number of stocks in the average well-balanced portfolio could reduce the portfolio's standard deviation to a maximum of 19.2% (this number represents market risk).
However, they also found that with a portfolio of 20 stocks, the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio's risk by about 0.8%, while the first 20 stocks reduced the portfolio's risk by 29.2%.
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 beyond which there is no further benefit from diversification.
The study mentioned above wasn't suggesting that buying any 20 stocks equates with optimum diversification. Note from our original explanation of diversification that you need to buy stocks that are different from each other whether by company size, industry, sector, country, etc. Put in financial parlance, this means you are buying stocks that are uncorrelated – stocks that move in different directions during different times.
As well, note that this article is only talking about diversification within your stock portfolio. A person's overall portfolio should also diversify among different asset classes, meaning allocating a certain percentage to bonds, commodities, real estate, alternative assets and so on.
Owning a mutual fund that invests in 100 companies doesn't necessarily mean that you are at optimum diversification either. Many mutual funds are sector specific, so owning a telecom or healthcare mutual fund means you are diversified within that industry, but because of the high correlation between movements in stocks prices within an industry, you are not diversified to the extent you could be by investing across various industries and sectors. Balanced funds offer better risk protection than a sector-specific mutual fund because they own 100 or more stocks across the entire market.
Many mutual fund holders also suffer from being over-diversified. Some funds, especially the larger ones, have so many assets (i.e. cash to invest) that they have to hold literally hundreds of stocks and consequently, so are you. In some cases this makes it nearly impossible for the fund to outperform indexes - the whole reason you invested in the fund and are paying the fund manager a management fee.
The Bottom Line
Diversification is like ice cream: it's good, but only in reasonable quantities.
The common consensus is that a well-balanced portfolio with approximately 20 stocks diversifies away the maximum amount of market risk. Owning additional stocks takes away the potential of big gainers significantly impacting your bottom line, as is the case with large mutual funds investing in hundreds of stocks.
According to Warren Buffett, "Wide diversification is only required when investors do not understand what they are doing". In other words, if you diversify too much, you might not lose much, but you won't gain much either.