One of the biggest dilemma most of the first time investors face is the number of stocks one should hold?
Have you ever thought that your diversification strategy is going to give you returns when the market slows down?
What is the best thing that you have done, just because you were told you couldn’t?
Diversification is most misused and misunderstood terms in the investing arena. I remember talking to a Director of a Broking house, and I asked him, On Diversification “What is the number of stock is ideal for diversification.” After a long pause, “I am not sure about others, but I make sure I am well diversified, I at least hold 30-40 stocks anytime at least in some stock I would be successful.”
What is Diversification?
One of the essential tools to reduce risk is diversification. Internal Risk can be aptly managed with right systematic research. The diversification is required for external risk. We have already discussed the types of externals one can be associated with.
You Can Be A Stock Market Genius, by Joel Greenblatt he has a different view when it comes to diversification, “Leaving some of your assets on the sidelines (i.e., Investment not in Stocks) should be your compromise to prudent diversification.”
Like the above example per se, your investments went over 40 stocks without any outside investments chances are when the stock market is bearish or flat the return would be minimal. There are possibilities a couple of stock would belong to the same industry itself.
The concept of diversification is not very old; this idea is as early as the ancient stock exchange.
Right Way of Diversification
I am going to teach you Step-by-Step Process for getting your Investment Diversification done in the right way.
At Macro level only part of your Wealth should be considered as an investment in Stocks. The right person to guide you on this is your Personal Financial Advisor.
Coming to stock market consider distributing your stocks which should not contribute more than 70% based on types of investment. Based on the nature of company and investment we have classified into few as listed below:
- Speculative Investment
- Hybrid Investment
- Defensive Investment
- Aggressive Investment
- Income Investment
Defensive & Income would take care of your investment during bearish market and flat market. Speculative and Aggressive will take care of return part of the portfolio. Thus ensuring that your portfolio is appropriately risk Managed.
On the other hand, the most portfolio manager would start with what kind of investment suits you for example if you in your 20’s to 30′ they would select an aggressive portfolio for you. I don’t say they are wrong perhaps another school of thought.
Myth of Diversification
Joel Greenblatt method, ” [A]s the number of stocks increase the returns are diminishing in nature,” I completely agree to this.
Ideal holding should consist of 10 high-quality stock bought considering Three Most Important Pillars of Value Investing. Most people talk about the risk of investing in stock market, I would like to emphasize the risk of not investing in stock market.
List of Myths that People have when talking about over-diversification.
- With Diversification Risk Reduces (Holding more than 30 stocks).
- Diversification Increase the Chances of Success.
- Overdiversification is the Safest Method.
Understand the number before over diversification as it makes little sense. Since this is neither going to increase the chances of your success nor going to reduce the risk.
The right way to pick stocks is when you get an invitation from the stock based on the three pillars of value investing.
The right way to diversify when you are doing your research is to have a portfolio of 10 – 12 stock. If you are not prudent enough to conduct and understand your research then the right way to invest in index funds or mutual funds.
You can always use fundamental screeners to get down to the best stock.
And you should never do that. Let me know your thoughts in the comments below!
Like this post? Share it with your friends!