One of the most popular methods of managing your investment risk is diversification. Simply put, diversification means to spread your risk out among multiple stocks, sometimes in multiple industries, instead of putting all your eggs in one basket. This helps to reduce the risk that each individual stock has on your portfolio, thereby protecting you from unexpected news that could send the stock of a specific company down. This is why many professionals recommended people invest in index funds that track markets like the S&P 500, because they are comprised of 500 companies from differing industries.
One misconception that many people have is the belief that the more they diversify the less their account will be hit when the market goes down. The problem is that 3 out of 4 stocks follow the direction of the market, and if the economy enters a recession like it did in 2008, almost all stocks will be hit regardless of how many industries you diversify into. While it is true that certain stocks won’t get hit as hard in an economic downturn, it won’t be enough to mitigate the losses from other more economically sensitive stocks you own. This is why a lot of times you will hear professionals say they are “raising cash”, meaning that instead of diversifying into more stocks to protect themselves, they are selling stocks and letting the proceeds sit in cash until market conditions improve.
Owning Stocks in Different Industries
Another thing to consider is that if you have less than 10 stocks, some professionals recommend that none of them should be from the same sector. An example would be in a portfolio of ten stocks, you shouldn’t have three of those ten in Exxon (XOM), Chevron (CVX), and Conoco Phillips (COP) as these are all oil and gas plays that tend to move in the same direction. Therefore you wouldn’t really be diversified as 30% (3 out of 10) of your positions are in the energy sector and if energy stocks go down, a large chunk of your portfolio will go down with it. This concept has been popularized on a segment called “Am I Diversified?” on the CNBC TV show Mad Money. During this segment viewers call in and ask Jim Cramer if they are diversified with the five stocks they currently hold. If any two of the five stocks are in the same industry such as two oil stocks, Cramer will suggest they sell one of them and look to buy a stock in another industry such as technology.
How Many Stocks Should I Own?
I believe this is a function of how much money you have in your account and also what kind of strategy you are employing. I have heard advice from professionals ranging from 5% of your account per stock or around 20 stocks, to 25% per stock or about four stocks. If you are taking a more active approach in your investments, then you may find that 5-8 positions are all you need. For me personally, using companies with high growth and great technical’s, I try to never own more than eight stocks at once. This is because from my trading experiences, as well as studying others who have had success using the same strategies I use, focusing on a smaller number of the best growth stocks has worked the best for me. Just because this strategy works for me doesn’t necessarily mean it is the best strategy for you. That is why you need to find a strategy that works for you and matches your risk tolerance levels. Not everyone can actively manage their portfolios so concentrating into eight stocks might not be the best approach in that case.
Another thing to keep in mind is the dangers of over diversifying, or in other words owning too many stocks. You need to be able to do the homework for companies you own as well as do research on potential future investments. If you own let’s say 20 stocks, it will become nearly impossible for you to stay on top of the news and effectively manage these 20 stocks in your portfolio unless you are doing it full time. The danger here is that your research may become less rigorous and therefore cause you to miss the early flags that could help identify when to buy or sell a particular stock. Therefore in order to effectively manage your portfolio, focus your time on narrowing down your list to the very best stocks to help avoid the trap of over diversifying.
To summarize, putting all your eggs in one basket when it comes to stocks is a recipe for financial disaster and is incredibly poor risk management. Also be careful to not over diversify, especially with smaller accounts (less than $100,000), as these accounts can become impossible to effectively manage. The key is to first decide what kind of strategy you are utilizing which will be determined by how active you can be in the markets. If you can be somewhat active in the management of your account, meaning you can buy or sell stocks several days a week, I believe a conservative target to shoot for is between five and twelve stocks for accounts under $100,000. This may seem like a large range, but think of it more as a scale. At the bottom of the scale ($10,000), I would try to find five stocks to buy and scale that number up as you get closer to $100,000. For accounts that have more than $100,000, you will probably never need more than 15 stocks unless you’re using a strategy that is reliant on numerous stock positions or until you start hitting much higher portfolio values.
I think this quote from Warren Buffett sums it up best,
“Wide diversification is only required when investors do not understand what they are doing.”
About the Author - Cameron Urdu is the founder and editor of How to Buy Stocks, an online resource created to educate beginners looking to invest in the stock market. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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