Stock Market Diversification

The question is - how much diversification?


Stock market diversification is a message that is one of the ten commandments of stock market investing. But how important is it for value investors?

Warren Buffett has suggested that investors diversify to protect themselves from their own stupidity.

However, investors usually don't have the insider knowledge about companies that Buffett may enjoy as a major share holder or a company director.

And we have all heard the following advice ...

Don't put your eggs in the one basket - But if you do, then watch the eggs!!


How Much Diversification?

Stock market diversification is generally considered to be a sensible strategy. The question becomes how much diversification?

While the average investor may need 20 stocks to feel sufficiently diversified, value investors may be confident to hold less since they have already minimized overall risk through the imposition of a margin of safety on each individual stock.

Another reason why value investors commonly employ less stock market diversification is that they tend to invest a significant dollar amount (such as five percent or more of the portfolio) in each investment.

This increases the incentive to do the proper research to build the confidence necessary to take a significant position in a particular stock.


Ways to Diversify

Another way to diversify is through mutual stock funds. However there are mutual fund risks that are in addition to the usual stock market risks.

Diversification may also relate to the degree of correlation of the stocks in the portfolio.

Positively correlated stocks tend to have price movements in the same direction. Negatively correlated stocks tend to have price movements in the opposite directions.

The idea is that by having a mix of positively and negatively correlated stocks, the overall volatility of the portfolio is reduced - and hence investment risk if you follow modern portfolio theory.

The trick is to determine which of your stocks are correlated and which are not. My online broker shows prices in green if the stock price is increasing, and red if it is dropping.

Watching the colors over time and over economic cycles provides me with some indication of correlation - which ones are red when others are green, and vice versa. But I don't get too excited about correlations.

I prefer to see all my stocks the same color - green!

Some stocks do well in good times and bad times. Food stocks and gambling stocks are usually good examples. We do have to eat but we don't have to gamble - but some of us do, through good times and bad!

This suggests that sector diversification is a good strategy. That is, making sure that your portfolio consists of stocks from a variety of sectors, and not concentrated in one industry sector if it happens to be the flavor of the month.


To Conclude

When I am thinking about diversification and the importance of diversification, I remind myself that the magic of diversification and minimizing stock risk lies not so much in the number of stocks in my portfolio, but in my stock selection and in the margin of safety that I have achieved for each stock.



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