Often you hear the term “portfolio diversification” thrown around a lot in investing circles. Some claim portfolio diversification eliminates undue risk. But most so-called financial experts don’t spend a lot of time talking about it in great detail.
This can be confusing for investors that are juststarting out and even those that have been investing for some time. We are here to set the record straight on the effect of diversification on portfolio risk, as well as portfolio performance. In addition, we will discuss what level to diversify investments in order to sleep well at night. This includes discussing whether lack of diversification leads to higher risk.
Portfolio diversification is the concept of spreading your assets across different types of investment classes and businesses. Also, diversification includes investing in companies of a different size.
As investors, most of us are accumulating assets during our working years to either provide for our families and/or make sure there is enough money upon retirement. Being able to live a comfortable and enjoyable life upon retirement is critical. One of the biggest risks to an enjoyable retirement is incurring an impairment to a very large investment that you can not recover from fast enough before you need the money.
A hypothetical example of diversification would be spreading your investment dollars as follows:
Portfolio diversification eliminates certain kinds of risk but does not eliminate it all. Here are three examples of the effect of diversification on portfolio risk.
Company specific (unsystematic) risk – Spreading your assets over at least 20 to 30 different types of businesses eliminates the risk that if any one company has a bad quarter or year, it will not have a sizable impact on the overall performance of your portfolio
Asset class risk – Spreading your assets among asset classes like stocks, bonds, precious metals and real estate eliminates the risk that when any one asset class is performing poorly that it will have an undue size impact on your portfolio performance for the year.
Macro (systematic) risk – Macro events like the Great Recession of 2008 and 2009, or the COVID 19 scare in 2020 will likely depress most asset prices. In general asset diversification can not help avoid losses from these types of events
There is no doubt that there should be some level of diversification in an investment portfolio. Under no circumstances should anyone invest all their money in just one investment, regardless of how much of a “sure thing” it is.
But there are likely millions of pages of investing literature written on the optimal level of portfolio diversification that needs to take place to deliver a safe and profitable return on your invested capital.
Most people seem to believe that you should include at least 15 to 25 stocks and bonds in a portfolio in order for it to be properly diversified. At that level, an average investment makes up 5% of the total. If f one of your companies turns into the lastest Enron and goes to zero in value, your investments will be impacted, but not devastated.
However, there are those who believe a more concentrated portfolio is the best way to deliver great returns. And if you do your research properly, you can do it safely. Charlie Munger, the great investing partner of Warren Buffet had the following to say about diversification:
“The idea that very smart people with investment skills should have hugely diversified portfolios is madness. It’s a very conventional madness. And it is taught in all the business schools. But they are wrong. If you can identify six wonderful businesses that is all the diversification you need. And you will make a lot of money. ………Very few people have gotten rich on the seventh best idea.”
What a great quote from Charlie Munger. The challenge for most people is that they either don’t have the time or the skill to do proper due diligence on an investment. As a result, they are hesitant to invest in only six investment, which would mean 16% into each.
You can see from the pros and cons of the different levels of diversification that there is no right or wrong answer. A lower level of diversification works for Charlie Munger given his skill level. However, for folks less sophisticated in due diligence, a higher level of diversification may be the answer.
In Summary
Regardless of whether your time horizon is short term or long term you want to build a diversified portfolio that has a reasonably market risk associated with it. In the end you want to achieve a reasonable return on your investment funds and sleep well at night not having to worry about them all the time.
The challenge is determining what level of diversification is right for you as an investment strategy to deliver the expected returns for your investment portfolio.
Everyone is different in terms of their investment goals and the level of risk you are willing to take on.
Particularly when just starting out with investing I suggest:
Doing these steps should lead to returns on your assets that are quite rewarding for you over the long run.
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