The Importance of Diversification: Part 1

Talk to any investor or financial advisor, and the rule of thumb to protect your assets is: diversification. This is part 1 of a two-part series (part 2 available here) where I discuss the importance of diversification. In this post, we look at the importance of diversification in investments. There are various complex mathematical models to determine risks in investments, which are outside the scope of this article and blog. For a simplistic viewpoint of risk assessment from a diversification viewpoint, consider the following chart (Image source: Nasdaq) comparing the Portfolio RiskGrade and the Number of Stocks.
Risk Grade vs. Number of Stocks
Risk can be either Unique or Systemic. As most investors know, investing in a company comes with a risk of the company either going under or just losing value, which results in the investor losing part or whole of his/her capital. This is called Unique risk. While investors can preserve their capital and investment by picking better companies, it is almost impossible to find a good investment without any inherent risk; as the old adge goes “Without risk, there is no reward”. As illustrated in the graph above, studies have shown that risk can be mitigated by investing in as little as 12 companies, and close to elimination with approximately 50 companies.
Systemic risk may arise from common driving factors such as broad economic factors (for e.g., recessions), war, natural disasters etc. The broad markets move when such events occur. Note that even with a  globally diversified portfolio of stocks, there is still a risk-grade of 100 in the graph above. This is the systemic risk.

My ThoughtsWhen I consider diversification for my investments, I consider it on three different levels: diversification based on asset class; diversification by sector of the economy; and geographical diversification. Another old adage that investors should remember: “Never put all eggs in one basket”.

  1. Asset class diversification is important for investors as relying on one asset class such as stocks, bonds, real estate or commodities exposes risk immensely. Stock market crashes of the yesteryears remind us how investor’s fortunes were gained and lost.
  2. Sector allocation: Investors should try to mitigate risk by investing in all sectors of the economy. I current own 20 individual stocks and 5 funds, which provides me with pretty good diversification. However, I still do not consider my portfolio completely balanced as it is lacking in certain sectors of the economy and it is an ongoing project on getting that balance right. Once I get it to a state I want it in, I will be cycling through my holdings and investing additional capital in the relatively undervalued stock/fund.
  3. Geographical diversification: The type of diversification often overlooked by investors is the geographical diversification. A lot of investors believe in the mantra “invest in what you know”. This, I find is a double edged sword. Yes, it is good to invest in companies that you know well if you are familiar with the business model and know how the company actually runs and turns profits and if the company has good future prospects. However, it is important to not depend only on your local businesses, but invest globally – esp now that we have all the tools available at our fingertips making trades available and affordable. This way, any local disturbances such as recessions, wars, natural disasters will not take a toll on your investments and the risk is mitigated.
Our Portfolio
Our portfolio diversification as of Jun 2014

As things stand, our portfolio is not so bad on the sector-wise asset allocation, but geographical diversification is very skewed to our home country (Canada). This big skew occurred after my wife and I merged our portfolios and all of her investments were focused on the Canadian markets. As part of my 2014 goals, we intend to rebalance our portfolios with better diversification.

What’s Your Number?

I can think of a few finance bloggers who consider 40-50 stocks to be a number that makes them feel that their portfolio is well diversified. Dividend Mantra posted on this topic a couple of months ago where he makes the case for his portfolio to contain 50 stocks to achieve enough diversification. What are your thoughts? Do you have a number in mind? How many companies would you want to own before considering your investment portfolio diversified?Full Disclosure: My full list of holdings is available here.

 

21 thoughts on “The Importance of Diversification: Part 1

  1. Hi R2R,

    Thanks for your thoughts.
    The US Champion list only contains as few as 8 sectors that has >3 stocks in it. IT and Telecom are relatively newcomers in this list, so not many companies in this sector had dividend raises for more than 25 years.

    I’m trying to get 2 to 3 stocks per industry. This way I think the portfolio of 20~30 stocks I then have are diversified enough. After that I’m willing to take a little bit more risk with Contenders or Challengers, but the diversification will be kept in tact.

    However all of this will be long term goal for me, as I started only recently. 🙂

    • DFS,
      Thanks for stopping by and the comment.

      True that the champions list has slim pickings when it comes to tech sector. It has more to do with the fact that technology is a relatively new industry and the companies havent been around long enough to get on the champions list. The next best thing is to go with telecom I suppose.

      2-3 stocks per industry sounds like a good plan. That seems to be what most investors follow – and I will probably go that way too. For now, I have 1-2 stocks per sector. I think going with Contenders and Challengers are a great idea as well – as they are not at such a high premium, so you can find some better value in the stocks (except maybe in teh current market conditions)

      Best wishes in your journey. Your blog is new to me..will be sure to check it out.

      regards

  2. I’m looking forward to reading the rest of this series R2R. I certainly consider 50 “well thought out” stocks to cover sector diversification. On stock diversification, I think someone needs to either go one way…..or the other. The Warren Buffetts and Peter Lynches of the world want their stocks in very few baskets…..and watch those baskets closely. I think the VAST majority of retail investors are better served by going toward diversification.

    I’m glad you mentioned Geographic and Asset Class risk also. There are times when all stocks in the developed world….or emerging markets…..or whatever, went down at once. I expect that most, if not all, sovereign bonds from the mature countries will crater when this bond bubble finally pops.

    We always try to buy what is feared and sell what is dear.
    -Bryan

    • Good points, Bryan. The Buffetts and Lynches of the world would want to go after some companies with a focus, but for smaller retail investors like us, diversifying amongst a larger basket of stocks and/or funds is the best option. That is the reason why Buffett and Bogle keep repeating that retail investors should simply buy low cost index funds.

      The geographic risk is often overlooked as investors seem to consider most companies to be worldwide powerhouses these days. While true, geographical diversification still protects the investors from local disruptions.

      regards

  3. R2R,

    Diversification is very important and I think bonds many times are overlooked. During good times bonds are often looked upon as dead money, small returns, or investments for retirees. I personally look at them as shock absorbers that can help remove knee jerk reactions and panic during rough times.

    I look forward to the next article.

    MDP

    • I agree, MDP. Bonds provide the stability that stocks cannot match. We continue to hold some high quality short term bonds, albeit a small percentage (about 7.5% currently).

      Thanks for stopping by and the input.
      R2R

  4. R2R,

    I’ve never really set a target for allocation between sectors, but I’ve kind of accidentally ended up so. I think if you’re after income diversification between a number of great companies you’ll end up with good diversification between the sectors. Of course, I also don’t think it’s necessary to diversify between sectors all that much. I wouldn’t diversify just for the sake of diversifying, and I feel some sectors (utilities, telecoms) don’t offer the kind of risk-adjusted returns that I’m after for the most part. I have some allocation there, but I plan to keep it very small.

    And fixed income is zilch for me right now. Again, if the asset doesn’t make sense I’m not going to go after it just for the sake of diversification. That’s just my $0.02. 🙂

    Best wishes!

    • Interesting approach, DM. Ive had similar discussions with others where they are not too concerned about diversification for the sake of diversification. But looking at your portfolio, it appears you are quite diversified, whether accidental or consequential. There are a number of studies that have concluded that diversification is an important tenet when it comes to protecting your assets.
      I believe bonds provide a much needed shock absorbing quality that stocks cannot and continue to hold a small portion of my portfolio, even though I dont see the greatest of returns in that asset class.

      Thanks for the comment and sharing your view, DM. Gives me some more food for thought 🙂

      regards

  5. Great Post. Lately I have put a lot of thought in my own portfolio in diversification. You can ask 100 people and get a 100 different answers on your asset allocation, global allocation and sector allocation. Real tough to decide what will ultimately work for yourself.

    I am 38% canadian , 52% american, 10% International with 56 stocks total.

    Max stocks i would want to hold is 75. I plan to increase my Intl holdings as I am too overly weight in the US. I may have to go to a ETF to boost my Intl exposure because of the light offerings of ADRs on the American markets.

    • You are right, Asset Grinder. Every person has a different answer starting from “you dont need diversification at all” (I had a discussion on SeekingAlpha on this topic yesterday, who was convinced that investing in just consumer staples and utilities provides him with plenty of exposure with minimal risk) to “it needs to be exactly x%”.
      Looks like you have a good mix. I would want to be somthing similar with an increase exposure in the US market. I sold my VXUS holding earlier this month, so after that transaction – my international holdings have dropped to an all-time low. I will be looking into Canadian-based ETFs instead to avoid losses in currency conversion costs.

      Thanks for the input

  6. As far as companies I’m thinking 40-50. Much more than that there’s just too much to keep up with and it seems like you’d be diversifying just to do it.

    As far as asset class diversification I’d still like to get some more real estate exposure but I do the majority of my asset class and geographic diversification through the funds offered in my 401k. I have capital going to bond funds (intermediate and not much right now because the yields just don’t make a lot of sense) and international funds to get the geographic. The problem with gaining geographic diversification is that some are prohibitively expensive to purchase due to additional brokerage fees and some (esp. China) doesn’t have the same financial reporting standards.

    I know it’d be a pain to do so but I’m curious what your geographic diversification looks like based on revenue from each company. It’d be interesting to compare it to your previous chart to see if there’s a big difference.

    Looking forward to part 2.

    • Thanks for the input PIP. I hear you on the pain after the 40-50 stocks. Im curious – do you include your primary residence in your real estate consideration? Some people do, some people dont.

      There are some good ETFs that should give decent exposure to the international markets and lucky for us, the costs keep falling. There are always some good ADRs to gain exposure to the international equity without the penalty of fees as well.

      That sounds like a great idea. I would be interested in finding out the geographic revenue diversification with my current holdings. I’ll add that as one of my work-items to follow up on.

      cheers

  7. I tend towards’ Nick Murray’s definition of risk and how to deal with it: “…the real risk isn’t losing your money. It’s outliving it.” and “Investments that preserve … purchasing power over the long term are safe.”
    So, by his view, bonds are far riskier than growth/dividend paying stocks.
    Also, don’t confuse volatility with loss. You only lose if you sell into a down market. So, I aim to create enough income from dividends I never have to sell anything if I don’t chose to!
    Once you have covered the basics, you might want to consider some small-caps (they consistently outperform large-caps) for the long-term health of your portfolio.
    I just posted a “How to” start with them: http://www.moneydiva.com/investing-know-how-small-capitalization-growth-stocks-2/
    Take Care – Leah, the MoneyDiva.com

    • Leah,
      Good points. Bonds are worse off than stocks for long term investments in the current environment. It baffles me that anyone is buying the newly issued bonds with a term of 10, 30, 50 years. Not just the government, but the corporations raising money by issuing bonds are getting a great deal by borrowing cheaply. Most of the bonds I hold are laddered with a very short duration (1-5 years) and provide a some much-needed inertia in the portfolio.
      Good point on the small caps…mid-caps and small-caps are completely missing from my portfolio and I need to look into for diversification.

      Thanks for stopping by and the input. Much appreciated.
      R2R

  8. Great vintage post R2R.

    You know my take on this one: I think holding 40-50 companies is way too much. You might as well buy an ETF at this point. But that is my opinion, and I know a lot of bloggers/investors own think differently.

    If you are diversified in your stocks (geographically, sectors wise, etc.) and these companies are dominating their sector of activities, raising their dividends regularly, I don’t see why you need to hold more than 15-20. Take for instance the Canadian banks. I hold BNS and RY. I don’t need to hold more, do I ? It will only hurt my return in the long run.

    Anyway, just a thought. 😉

    • Interesting thought, MD.
      I have a couple of points to counter that 🙂

      Not all ETFs pass on the dividend raises to the consumers, so the kind of dividend growth that is achievable by owning individual stocks is not possible with ETFs. Moreso, ETFs are relatively new, so they dont have any track record on that front.
      The second and more important point, atleast imo, is that you have to take the whole package and the ETF’s weightage. So, you have to take the good with the bad stocks all packaged into the ETFs and lots of ETFs out there would allocated majority of the funds into say the Financial sector. I’d rather have my own diversified weightage instead of owning an ETF which would allocate a third of its funds to one sector.

      Thanks for stopping by and sharing. Always great to hear counter arguments 🙂
      R2R

  9. Hey R2R,

    I don’t know all of the ETF’s obviously but to my knowledge they must me passing on the dividend increases. Why wouldn’t they? They do it for traditional funds…

    As for your second point, they have so many new ETF’s out there that there has to be one that fits your profile. But the point you are bringing up is true. One bad apple could contaminate the whole thing. However this is also true with a portfolio of over 40-50 stocks. You have more chance to hit one bad apple with that many stocks than with 12 excellent ones for instance.

    I guess it’s an open debate! Looking forward to read your new post! 😉

    • Good points, MD.
      The chances of bad apples ending up in individual stocks is just as real…in fact, the likelihood is probably higher than an index based funds. Look at the recent problems with ARCP – most DGIs owned that company and recently it was found that the management was lying and cooking their books – and eventually slashed their dividend. I suppose it could happen anywhere, but with major index components, the likelihood is smaller.

      As for passing on the dividends – I have closely looked at two ETFs which track the dividend growers, and the increases are either minimal or gyrate with more randomness – so its hard to judge. One ETF lowered its payouts, which was attributed to capital return and then had a one-off annual payout, so its not a steady stream of income as with regular stocks. The lack of track record also makes it a bit of a unknown.

      It sure is an open debate. I should be able to post something next week on it. I already have the posts lined up for this week 🙂

      cheers
      R2R

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