I got a great question over email about over-diversification and wondering how many different stock sectors one should own. Here it is:
Thanks for all the great information. I look forward to your emails every week. The one thing I struggle with when it comes to investing is the variety of stocks I think I should own. I want to be diverse but not diluted. I know it is impossible to have every base covered. However, do I balance cyclical with non-cyclical stocks, medical with consumer discretionary balanced with consumer staples. When and where do I stop buying new stocks and simply grow the ones I already have? I am not afraid of research but I don’t want spend all my free time researching new companies. Thanks.
I agree that it is impossible to have every base covered. In fact, you don’t want to be too diversified because at a point you are minimizing the benefits. I talked about this in-depth with David Thomas from Shares and Stock Markets, and in the video we share that the positive benefits of diversification really diminish after 20-25 stocks.
If you use a diversification like that, then you are only exposing your portfolio to 4-5% on each position, which is ideal. You’ll find that 5% number as a popular metric for a lot of technical traders, who often trade much more frequently and pride themselves in risk management.
Those of you familiar with the CNBC tv show Mad Money know about the segment where Jim Cramer looks at a portfolio of 5 stocks and decides if it is diversified enough. I really believe that 5 stocks aren’t enough.
Think about it. A portfolio with only 5 stocks means a 20% exposure with any one position. If a position goes south 50%, which isn’t impossible in the slightest, you’re talking about a wipeout of 10% of your portfolio. Even with experience under my belt in the stock market, I still wouldn’t be comfortable to put that much risk on any one stock pick.
You have to think about the worst case scenario. Nobody is that good at investing that they can disregard that fact. We are all subject to the same market insensibilities.
So I strive for a portfolio of 20-25 stocks.
When to Stop Buying Stocks
This leads to another part of the question which is when to stop adding to positions. My answer is never.
As I talked about in my 7 Steps to Understanding the Stock Market, the best tip I can give anyone is to dollar cost average. This means you set aside the same amount to invest every single month. No matter if the market is going up, down, or sideways, you will make money in the long term if you are consistently adding to your positions.
So how to do this while also avoiding over-diversification?
Simple. Just buy more of what you already have. Let’s say you have a healthy, balanced portfolio of 25 stocks spread out between many stock sectors. Instead of buying more stocks or more stock sectors, add to the positions you already have. Find the companies that are still undervalued, and add to your positions.
If you had enough confidence in the beginning to put your money into that position, then you should still be willing to buy more.. assuming that the price hasn’t run up since. If the value is there, then as Cramer says buy, buy, buy.
Different Stock Sectors
As a part of your diversification, you’ll also want to make sure that you are exposed to a wide variety of stock sectors. Having both cyclical and non-cyclical stocks in your portfolio is very important. [click to continue…]