Diversification is the idea that you shouldn’t keep all of your eggs in one basket. The rationale for this idea is that if one of your investments goes bad, you will still have other types of investments that won’t be affected. You will be protected from this decline by your diversification. There are different ways to diversify your portfolio, ranging from the types of assets you buy, the number of different investments you keep, the sector focus, and the country.
a. Asset Allocation
Diversifying through asset allocation means to manage your portfolio by holding different types of assets, such as commodities, stocks, bonds, cash, real estate, or even fine art. However, most Investors traditionally focus on a simple asset allocation of stocks, bonds, and cash. As this chart shows, choosing the appropriate combination of assets can have a tremendous impact on your long-run returns and your probability of having short-term losses. It shows the expected returns of some commonly recommended asset allocations:
While it appears that only the most conservative asset allocations include cash, you will always have some cash in your portfolio. This will often come through dividends or regular cash deposits. How you manage this extra cash is also an important part of asset allocation. Passive investors usually have little trouble holding cash in their account, but active traders are sometimes tempted to make investments even when it is more prudent to hold cash.
If you are a more aggressive investor, you should try to keep your cash allocation at less than 10% of your portfolio unless you cannot find anything offering better returns. Holding large amounts of cash significantly lowers your potential returns, but you should still be careful to consider whether alternative assets are any better.
b. Portfolio Concentration
The number of different investments you hold is another important point of diversification. Sometimes investors will try to hold as many stocks as possible in order to reduce the impact of bad investments, but holding a large number of diverce investments can be just as harmful to your portfolio as only holding one stock.
In a study of theoretical portfolios using a 10-year time frame, comparing portfolios of 15 stocks, 50 stocks, 100 stocks, and 250 stocks showed that the highest percentage of market-beating portfolios came from the most concentrated portfolio. The results were clear:
- 15-stock portfolios beat the market 27% of the time.
- 50-stock portfolios beat the market 18% of the time.
- 100-stock portfolios beat the market 11% of the time.
- 250-stock portfolios beat the market 2% of the time.
[Source: The Warren Buffett Portfolio by Robert Hagstrom]
The smaller your portfolio, the more likely you will beat the market, and the easier it is to keep track of your investments. Common portfolio concentration recommendations are between 5 and 10 thoroughly researched holdings. This concentration can be increased to between 3 and 5 holdings when you become an expert level investor.
c. Sector Concentration
Diversifying by sector is sometimes considered just as important as diversifying by stock. For example, if you make all of your investments in technology companies and the market for technology stocks crashes, then you will lose out even if your stock holdings are heavily diversified within the technology sector. This is exactly what happened to many people during the technology boom of the 1990’s and the market crash that followed. Anyone who had a portfolio concentrated on the technology sector lost much more money than those who had diversified their portfolios to multiple sectors. Common recommendations say to hold stocks in at least three unrelated market sectors.
d. Foreign Concentration
Investing in foreign markets is usually not considered an important form of diversification, but it is worth reviewing.
In the long run, a country’s stock market performance will follow the growth of its economy. So if you conclude that another country will grow faster than the US (or wherever your home country happens to be), then you might consider diversifying into some foreign investments. It might also protect your investments from inflation.
However, foreign investments carry some unique risks. Currency price changes and unknown political environments would become larger factors in your investment decisions. Because of this added complexity, many recommendations say that foreign investments should be made through mutual funds.