Having the Right Amount of Diversification

Today I’ll continue the thread on lifelong investing, which started here.  In the last post in this series, I discussed the effect of volatility.  Today, I’ll discuss diversification.

It is uncommon for single stocks to drop by half or more over short periods of times but it
certainly can happen.  If a scandal breaks out or a large lawsuit
occurs, a stock may go bankrupt in a period of days.  For this reason
it is not a good idea to put more into a single position than one is
willing to lose.  Probably the worst thing a person can do is invest
all of one’s money in shares of the company for which one works.  In
that case if the company has sudden financial problems, or the CEO
gets indicted, you can lose your job and your investments in one day
(see Enron).

To reduce the risk of a substantial loss due to an event happening to any one security, one
uses diversification.  Diversification is spreading out one’s
money over several stocks, asset types, and even regions or
countries.  By buying several different assets, a loss due to some
random event will be limited.  For example, if one owns 10 different
stocks in equal amounts, one can only lose 10% in any individual
stock even if one drops in price to zero.

Note that this also works when prices go the other way.  By buying more than one stock, one
increases the chances of buying one that will be the next Microsoft
and increase a thousand percent or more.  A balance must be struck,
however, between buying enough different stocks/assets to provide
sufficient protection and yet still buying enough of each asset to
provide a good return.  If one bought Microsoft in the 1980’s but
only bought 10 shares, one would still have made only a few thousand
dollars despite the huge increase in share price.  If one had bought
1000 shares, one would be a multi-millionaire.  The amount of
diversification appropriate depends on life state,  asset balance,
and personal risk tolerance.

If one buys enough different stocks, or buys a few mutual funds, one will get about the
return of the stock market, which generally ranges between about -10%
and +15% in a year, but can see swings of between -50% and +100% in a
year time period.  During the Great Depression, the market fell by
90%, but then proceeded to rally back, increasing tenfold (1000%) in
the years that followed.  In 2008 stocks fell by about 50%, but then
rallied back within the next two years.  During the current bear
market of 2011, we have seen shares fall by about 15%.

If one includes different asset types beyond stocks (like bonds), one will get a return that is
the weighted average of the assets purchased.  For example, if one
had a portfolio of 50% bonds and 50% stocks, and stock returned 15%
and bonds 7% over a ten-year period, the total return for the
portfolio would be 11%, which is less than the return for a portfolio
consisting of only stocks.  Because the declines in bonds, however,
tend to be less than those for stocks, the 50-50 portfolio would be
safer than the 100% stock portfolio.  Remember that getting greater
returns always requires taking more risk.

While diversification into several different stocks reduces the effects of a bad event at
any one company, it does not reduce market risk.  Market
risk is the chance that the entire market will decline, taking good
stocks with bad.  For example, in the period of 2007-2008, most
stocks declined by 50% or more.  Even if one had 10 different stocks,
one still would have had a large negative return for the period.

To reduce market risk, one needs to buy uncorrelated assets or negatively correlated
.  The former are assets that move independently of each
other, for example, stocks in China and real estate in Seattle.  The
latter are assets that normally move opposite to each other.

Diversification reduces risk, but lowers returns.  Too much diversification when one is just
starting out will therefore limit the rate of growth.  That is fine
if you are happy with the market returns, which are not bad.  When
you are starting with very little capital, however, and have a long
time horizon (see the next section) that allows you to recover from
mistakes, it sometimes makes sense to use less diversification.

With heavy diversification, one needs to buy both favorite stocks and
less-than-favorite stocks.  When one is trying to grow wealth, it
makes sense to concentrate in what one thinks will be the winners.
As net worth builds one then begins to worry more about  return of
capital than return on capital; therefore, diversification should
increase as one shifts from trying to increase wealth while young to
trying to maintain wealth when older.

A good strategy is to have a portion of your portfolio devoted to growth and a portion devoted to capital preservation.  The growth portion should consist of moderate positions in your best pick.  The preservation portion should be made of mutual funds or ETFs that have low fees.  Starting out, the entire portfolio may be growth stocks.  As the portfolio grows and preservation gets more important, you will gradually shift to preservation.  Note that if you are successful, the dollar amount invested in growth stocks may stay about the same since the size of the portfolio will be growing.  With a multimillion dollar portfolio, it would certainly be appropriate to have a few hundred thousand dollars in growth stocks even if one were retired since it would still only represent a small portion of the portfolio.

Have a question about investing?  Please send to vtsioriginal@yahoo.com or leave your question in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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