You would have often read or heard about portfolio diversification in the context of your investments. Investment advisors and gurus advocate a diversified portfolio as diversification reduces risks. However, is there a potential danger of over diversifying? How much portfolio diversification is enough? We look at various aspects related to diversification in this post.
What is Portfolio Diversification?
Ratan explained to him that portfolio diversification is an investment strategy that entails investing in different asset classes including debt, equity, commodities, etc., and also investing across different themes, sectors, and market capitalisations within each asset class.
The next question that came to Prem’s mind was, ‘why is portfolio diversification important’?
Portfolio diversification refers to spreading your investments around to limit your exposure to a particular asset, industry, or company. Diversification is an investment strategy; you spread your risks across multiple industries, different asset classes, and maybe across countries too.
If you buy stock of XYZ Bank today, then the next addition to your portfolio should ideally be stock from a different industry like IT or FMCG, or you could choose to invest in bonds or debt mutual funds. Adding banking stocks is not a good idea as it skews your exposure towards the banking sector, thereby increasing your industry-specific risk.
If picking what to include in your portfolio seems confusing, then Stoxbox is the ideal solution. Stoxbox is a basket of equities, MFs, or ETFs that can help you build low-cost and well-diversified portfolios.
How Does Portfolio Diversification Reduce Risk?
There are diversifiable and nondiversifiable risks in a portfolio. Diversifiable risks are unsystematic risks that you can minimize with the right strategy. In a diversified portfolio, you spread your investments across different asset classes and industries, reducing the overall impact of market volatility.
When you diversify your holdings by investing in a variety of investments, you get a cushion against risk. The underlying belief is that the gains generated by one investment effectively balance out the losses that you may incur in another investment.
Diversification reduces sector-specific, asset-specific, and enterprise-specific risks. Portfolio diversification reduces risks and generates higher returns in the long run.
How Much Portfolio Diversification is Enough?
Excess of anything can be harmful. How much portfolio diversification is enough can be a tricky question. Your investment risk can be mitigated but not eliminated. So, do not add to your portfolio blindly. No matter how widely diversified a portfolio is, you can never eliminate the risk.
Too many stocks or mutual funds in your portfolio can reduce your returns. Keep the trade-off in mind when you plan your portfolio. Over diversification can erode your portfolio performance.
Portfolio Diversification: How Many Stocks are Too Many?
There are different theories regarding the optimum number of stocks in a diversified portfolio. A few studies by experts on how many stocks are too many for a diversified portfolio are as follows:
In 1968, John L. Evans and Stephen H. Archer published a study based on empirical analysis. They stipulated that a fully-paid, debt-free portfolio (without any margin borrowing) consisting of 10 randomly chosen stocks could mirror the stock market as a whole. This approach where random stocks are selected without any analysis is known as “naive diversification”.
Two decades later, Meir Statman published a study; as per him, you should have a minimum of 30 stocks for adequate diversification if you are a debt-free investor. For investors using borrowed funds, 40 stock positions were required for a diversified portfolio.
Benjamin Graham, who was the proponent of value investing, suggested that investors should have at least 40 stocks in their portfolios to reduce risk.
If you think that having 40 stock positions for portfolio diversification is enough, then think again!
A study called “Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough” was carried out in 2007. It concluded that a randomly compiled portfolio had to include 164 firms to reduce the chances of failure to less than 1%! As per the study, a 10-stock portfolio had a 60% probability of success; a 50-stock portfolio had an 87% probability of success. With more than 100 stocks, the success probability rose to 96%.
Warren Buffet had a different opinion and famously said, “wide diversification is only required when investors do not understand what they are doing. ” As per him “Diversification was protection against ignorance”. Buffet believed, you should study one or two industries thoroughly and use that knowledge to maximize your gains rather than spreading your investment across sectors and companies.
However, you and I are not Warren Buffet; we do not have the same level of expertise. You can take the help of experts to design your portfolio.
You can choose which of the above approaches works for you best. One thing that Mr. Buffet points out is crucial to remember. You cannot benefit from any strategy if you do not know what you are doing. Doing your research can help you get the returns you want. Here is a beginner’s guide to start investing to help you kickstart your investment journey.
Undoubtedly, diversification helps reduce risks. Mutual funds are a great example of that.
Portfolio Diversification In Mutual Funds
Mutual funds offer the easiest route to diversification. When you invest in a mutual fund, you are indirectly investing in a basket of securities or instruments. So whether you invest in an equity fund, a debt fund, or a balanced fund, your money is spread across different companies and sometimes sectors and instruments too.
You can choose to invest in an equity fund; depending on your risk appetite and strategy, you could pick thematic funds or a large-cap fund. If you are looking at adding fixed-income investments to your portfolio, you can choose to invest in debt funds. Balanced funds are more diversified than debt and equity funds as they have both equity and debt components in the portfolio.
Why is Diversification Important for Young Investors?
Young investors can take higher risks when compared to older investors. If you start investing early, you can take more risks and thereby earn more returns. You can choose to diversify your investments across equity and reduce your exposure to a particular sector or company.
With time by your side, the magic of compounding and your ability to take higher risks can help you accumulate a large corpus over time. Before you start investing, do go through the rules of trading so that you can do thorough research before you begin investing.
Investments make your money work for you. There is no perfect number of stocks or instruments you must include in your portfolio to reduce your risks. Choose what works for you based on your goals, risk appetite, and what you can manage.
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