Diversification - How Much is Enough?

Given that financial markets have been fairly turbulent lately, I think diversification has become more important than ever. If you are well-diversified, part of your portfolio may do poorly, but as a whole it should be fine. The question is, how much should you diversify?


The whole concept of diversification is to minimize your risk or that chance that your performance will perform poorly. Buying companies in different industries can help minimize the inherent risks of each industry. One industry may be in trouble, but if you’ve chosen correctly, these difficulties can be offset by gains in other industries.


You can also buy different classes of assets – such as stocks, bonds, mutual funds – which can help lower your overall portfolio risk. Each class will behave differently depending on economic conditions. For example, bonds and stocks move in different directions and knowing this fact can help plan what you put inside your portfolio.


But the question then becomes: how many stocks or investment instruments do you need to own to maximize your diversification or minimize risk? The article “The Dangers of Over-Diversification” by Investopedia.com suggests that the benefits of diversification diminish after owning more than 20 stocks – basically, owning any more than 20 stocks isn’t going to lower the risk much to make it worthwhile.


What implication does this have? Well, I think people need to take a hard look at the mutual funds they own. If these funds own hundreds of stocks, they could be over-diversified or worse, if they own lots of companies in the same industry, you won’t be diversified at all. The only people benefiting are the companies charging the high management fees and brokers making nice commissions.


I read a story in a great book called ‘The Naked Investor’, by John Reynolds, where some people owned up to 10 or 20 different mutual funds as chosen by their investment advisors. Given that each mutual fund probably owned 100’s of different stocks, there could have been situations where different mutual funds owned the same stocks! This isn’t diversification at all and I suspect other motives – huge commissions – were at play.


And therein lies one of the main issues – commissions and transactions costs. You could end up paying too many fees if you own a huge number of investment vehicles and not even getting any benefit at all. So, what would I do?


I would probably start out owning just a few mutual funds and I probably wouldn't own any industry-specific ones. If you get a specific fund in one industry then the whole fund is subject to the risks of that industry. I would want a general equity fund or something like that.


Mutual funds are a great vehicle if you’re not inclined to do the investing yourself or don’t have the time. I would certainly watch what my advisor was purchasing and question anything that seemed out of the ordinary – ie. frequent transactions, different mutual funds in the same industry or class.


At some point, I plan on going self-directed with my portfolio and will probably keep the number of stocks less than 20. As a matter of fact, to keep things simple, I’d probably keep the number to 10, hopefully, well-chosen stocks.

Related posts:
What Type of Investor are You?
Choosing a Financial Planner
Investing in Mutual Funds