One of the classic concepts of investing is diversification. It also poses a classic question: how much should investors diversify?
Diversification in investing hits at several levels: how many stocks do you need in your portfolio? Should you diversify between stocks and other asset classes? If you own a house, how does that affect your diversification? A friend and former colleague of mine added another level: if you work in one field, should you avoid investing in it in your portfolio, since you already have your eggs in that basket?
All of those topics are worth discussing, but I want to start with the first sub question: how many stocks do you need in your portfolio? Like so much in life and investing, there is no one answer. But I want to share some concepts to help get at that answer.
It’s important to know, before we begin, that your level of experience should affect how much you diversify. The less experience you have, the smarter it is to diversify. But we’ll get into that.
Why Diversify?
Don’t put all your eggs in one basket. A classic edict, and the underlying reason to diversify.
When we build a stock portfolio, buying multiple stocks is a benefit because we don’t know the future. We don’t know what’s going to happen. There’s every chance that we will be wrong about which stocks to pick.
If instead of holding only one stock, we hold ten, then no one stock will kill our portfolio. It’s true that ‘scared money don’t make money’, or that you have to put money on the line. But balancing that risk will help you stay in the game over years and decades, which is a key factor in surviving and thriving in the stock market.
It’s not just that your analysis might be wrong. You could do good analysis, and things might just go wrong. Something could happen at the company or in the world that is unpredictable, or unlikely, that could hit a stock hard. Our job as analysts is to try to anticipate these things. But we can’t anticipate every possible risk. And we take on some risks anyway, because we think the price is worth it. If we have some diversification, we will be able to keep our seat at the table longer.
The flip side of that reason is that it’s hard to get stock picking right. If you give yourself 5 or 10 shots on goal instead of just 1, you have a better chance of getting them right. Again, by spreading out your eggs, you have a better chance of one hatching into a great portfolio pick.
Undiversified portfolio. Source: Autumn Mott Rodeheaver on Unsplash
Why not diversify?
We can invert most of those arguments though.
Starting with the last one: there’s an old saying in investing that your 10th idea is never as good as your best idea, and your 50th isn’t as good as your 10th. It’s hard to get stock picking right, so wait for your fat pitch and only swing then.
If you just add stocks to your portfolio to reduce risk, you also reduce your chances of return. You risk, instead, diworsification. Diworsification is essentially the idea of putting too many stocks in your portfolio, with each new one diluting your results. If you have 10 stocks, then hitting it big on one will have a big impact on your portfolio. If you have 100 stocks, hitting it big will have a much smaller impact. Once you get to that point, why not just own an index fund?
Remember that when we are investing actively in stocks, we need to spend time studying those stocks. Even full-time investors can only follow so many stocks well, and most of us are not full-time investors. This is another argument for not over-diversifying: you’re not likely to have so many great ideas, and you can’t stay on top of all those ideas.
Considerations for how much to diversify
Before weighing in on either side of the aisle, I need to add other considerations. These are factors that might change how you want to diversify:
How much money are you investing?
If you are at a stage in your investing where the goal is to accumulate and grow wealth, you may want to tilt more towards concentration (i.e. fewer stocks) and less towards diversification. The big winners will be what makes the difference in growing your wealth, and those are hard to find.
Once you reach the point where you want to protect your wealth, diversification becomes relatively more attractive. It is more of a defensive tactic, to spread your money around so no one stock can sink your financial position.
How much money are you saving?
Conversely, where you are in your professional life matters. If you are saving a material amount of money, and expect to continue to grow your savings over time, you can be less diversified. Your professional income gives you a cushion in life and will also grow your portfolio, giving you new chances. As long as you don’t keep sinking money in the same losers over time, this becomes its own form of diversification, rather than you needing to own 30 stocks from day 1.
How open to risk are you?
Your risk tolerance is a related concept. That can mean several things, but I think two are most relevant. One is when will you need the money you’re investing? The longer that time horizon is, the less the risk of a bad year matters. You can rebound from one bad year, as long as you are learning and finding out new things.
The other is, how badly will you feel if you have a bad day or week or month or year? Can you stomach seeing red numbers? On October 5, I got bad news for two of my biggest positions (8.4% of my portfolio), and they each dropped 25%, taking my portfolio down more than 2%. If you have a hard time with that, wider diversification will give you a better chance of avoiding big drops.
How experienced are you?
I’ve said this once but I will again. It makes sense that as you gain more experience investing, you can feel more comfortable in your picks, which makes an argument for less diversification and more concentration.
Conversely, if you are newer to investing, diversifying a little more is also a way to get more practice. If you invest in 12 stocks instead of 6, in theory you get double the opportunity to learn.
It’s said that a little knowledge is a dangerous thing, and I don’t think one should literally follow a path where, say, each year their portfolio gets a little more concentrated and less diversified. But it’s fair to say that concentrating your portfolio in fewer positions is a more advanced portfolio strategy.
My Take on Diversification
The following is not strict investing or investment advice, but how I think about diversification. There’s no doubt diversification is a useful and advisable portfolio strategy. There also comes a point where it can be too much of a good thing. Many studies have found that for individual investors, most of the benefit from diversification – in terms of controlling for ‘non-market’ risk – happens when you have 6-8 stocks.
I think it’s smart to target something like 6-10 stocks in your portfolio, as a starting point. You can weigh in all the considerations above for how to adjust that number. At 6-10 stocks (see caveat in a minute), you get adequate diversification to limit the pain of one or two stocks going wrong, while still putting yourself in position to really grow your portfolio if you get one or two stocks right.
The important caveat is: you have to make sure your stocks are actually different from one another. We’ll talk more about that in another post, but for now, buying Nvidia, AMD, and Intel, all leading semiconductor companies, would not represent real diversification.
A portfolio of 6-10 stocks, and a watchlist of 10-20 stocks you are interested in is a long enough list to get practice following the market and to give you every chance at diversification, without being so long that you can’t follow those stocks and hold down a day job. You can re-balance your positions over time if you’d like, but it also allows you to let winners run. (Don’t worry, we’ll cover both concepts later).
Then, as your portfolio and experience grows, you can consider getting more defensive – more diversification – or more offensive – less diversification and more concentrated, depending on your goals and your experience.
One variation – index + investing
One other concept I want to squeeze in relates to indexing. Let’s say you index, but then you stumble on a great idea. You can consider maintaining your index position while investing in just that one stock at whatever percentage of your portfolio you’re comfortable with. As long as you are still majority invested in the index, you will have decent diversification.
In other words, if you index and then find one great idea, it’s not necessary to fill the portfolio with 4-5 other, less great ideas, just to diversify for that one idea being risky. The index is already there for that.
How I approach diversification in investing
When I started out, I targeted about 10 stocks. I bought a total of 16 stocks in my first year of investing, and sold five of those positions in full, relatively quickly. I wasn’t super diversified – I had a lot of healthcare companies that were related.
Once I started managing my wife’s account, and then more family members, I went in two directions on diversification. On the one hand, I didn’t pool our positions enough, so if person A had it, person B wouldn’t. Not all the time, but frequently. Each individual portfolio would have 10-15 stocks, but that would lead me to managing 35-40 stocks.
I eventually recalibrated to where I am now. I own around 30 stocks plus one short position. Individual portfolios have anywhere from 11-25 positions, which is mostly a function of how big the portfolios are and the goals.
For me, as someone who is professionally investing and following the market closely, that seems like a manageable number. And while I have a decade of experience under my belt, I still always have doubt in my analysis or the market, and feel like diversification is one way to manage that doubt. I still had a couple stocks that each moved my portfolio up 6%, a sign of the impact getting one right can have, so the balance is ok for me.
One last thing I’m working on is being quicker to open positions in stocks I’m interested in so I don’t totally miss out. These can be smaller positions. So while I had 26 long positions at the end of the year, 13 of my positions make up 61% of my portfolio, which is reasonable concentration.
In all things, even diversification, moderation
Your taste for diversification in investing will be like your investing style: unique to you, with no perfect answer. I’ve been told I diversify too much, and I know people who prefer to just put their eggs in the baskets they’re studying very closely. I’ve also seen professional investors who like to own 100 stocks, which seems crazy to me. But to each their own.
It’s important to understand why one would diversify, what the trade-offs are, and what we should consider before deciding how diversified we want to be. I’ve laid out those eggs here. It’s up to you to decide which baskets you want to put them in.