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.
For those who don’t know the meaning of cyclical, it means that a stock that is dependent on the economy to do well. Industries like the auto industry, who depend on consumer confidence and general excess of consumer money to make big profits, are typical examples of cyclical stocks.
Now keep in mind that you don’t have to have a 50-50 split between cyclical and non-cyclical stocks and stock sectors. In fact, I think a portfolio should be much more heavier in cyclical than not.
Think about the history of the market and economy. In both recent and long term history, both the stock market and the state of the economy has steadily improved in an almost linear fashion.
Yes there have been bear markets and stock crashes, but generally stocks and cyclical sectors have done well. I look at non-cyclical stocks as more of a hedge just in case the economy turns.
How to Include Every Sector?
Here’s the thing. You don’t want to own every sector. Some stock sectors have completely disappeared over time, either due to innovation and technology or because of a simple lack of demand. Not every sector is going to find success.
I even wrote about some research I did about the most bankrupted sector in the stock market. After going through the numbers, it shocked me to find out that of all the major bankruptcies in the past 2 decades, the retail industry had the most. This is an industry that so many beginners first get started into, and yet it can be potentially the most dangerous.
Would it kill your portfolio if you didn’t have any exposure to retail? On the surface it might seem like yes, but I’d argue that you’d be fine. Based on the research and track record, it’s a risky sector. This is why you must be diligent in your research. A stock MUST have a strong balance sheet, earnings, and cash flow.
Keep in mind that stock sectors go through bear and bull markets just the general stock market. A good indicator of whether to stay out of a stock sector is to look at mainstream media. The sectors that analysts are calling “hot” and “booming” are usually the ones that kill investors later. Beware.
Do whatever feels safest for you, but don’t buy into an expensive sector just because you are trying to meet a diversification need. It should be something to always keep in mind, but remember that value is more important.
It’s good to strive for diversification, but I think limiting yourself to a strict allocation (i.e. 75% cyclical, 25% non-cyclical, etc.) can have the adverse effect of resulting in missing some great gains or buying too high.
And if you find yourself running out of time from doing too much research, as many of us busy professionals do, check out my newsletter service The Sather Research eLetter. I share my best research ideas every month.