How Diversified Is Perfectly Diversified?
A concept any investor learns at the beginning of his investing career.
It’s a straightforward idea. You’d figure most would get it right.
Unfortunately, most investors don’t understand how to achieve proper diversification.
Some diversify too little… and some overdo it.
I can’t tell you how many times I’ve come across an investment portfolio that contains way too many stocks.
I’m talking about 50, 100, or more if you count ETF holdings.
“I prefer to play it safe and stay well diversified,” is the common rationalization.
What these investors don’t realize is that, after a certain point, the effects of diversification diminish, no matter how many more stocks you add to your portfolio.
And The Magic Number Is... Drumroll, Please
Let’s play a game.
I want you to try and guess how many stocks you need in a portfolio to be completely diversified.
Now, hold that number in your head.
I’d bet I’m going to shock you when I reveal the actual number…
Which I’d also bet is a much smaller number than you imagined.
It’s not 50, 40, or even 30…
You can achieve complete portfolio diversification with only 20 stocks.
I know I was at first… until I worked through the logic.
Diversification Effects Drop Exponentially The More Stocks You Own
Let’s say you were to buy all the stocks in the S&P 500 Index and hold them for years.
Your average annual return would be roughly 10%, with a standard deviation of around 20%.
Statistically, a 20% standard deviation means that your returns are 20% higher or lower every couple of years. The 20% represents the market’s volatility. If you look at any stock chart, you’ll see that price never increases in a straight line.
If you were to purchase only a single stock from the S&P 500 Index, your rate of volatility would be much higher—roughly 50%.
That’s because the greater the number of stocks, the lower the volatility.
If you were to purchase three stocks instead of one, your volatility would drop by about 12% to 38%—a significant improvement over holding a single stock.
And if you were to add two more stocks to your portfolio, your volatility rate would drop by another 8% to 30%. Add another two, and you’d be down at 27%.
Another two, and you’d be at 25%.
Are you seeing the pattern?
For every two stocks that you add, volatility drops. However, the decreases become smaller with each addition.
By the time you reach 20 stocks, volatility drops to about 22%, nearly the same level as the S&P 500’s 20%.
You would need to add another 480 stocks to decrease volatility by an additional 2%.
That’s excessive… especially when just 20 stocks give you near-total diversification.
And there’s another reason why holding fewer stocks is better…
Fewer Stocks Means More Control
It’s a lot less work to manage 20 stocks.
The news, price action, annual reports, and so on… A prudent investor must process all that information for every stock he holds.
Why give yourself extra homework if there’s no need? Keeping up to date with 20 stocks is difficult enough.
So the real question is… which 20 stocks should you own?
If you’re like me, you want your stock picks to be safe, you want them to be trading below their intrinsic values, and you intend to hold them through your retirement.
That’s why those are precisely the types of stocks I cover in my monthly newsletter True Retirement Wealth.
Every month I send out a specific market opportunity and highlight a stock that will profit from it.
In addition, my subscribers get access to all the previous issues, as well as any special reports we might release outside the regular publication schedule.
In this month’s issue, I’ll be talking about 5G and my favorite stock in this sector.