Why Portfolio Diversification Is Important

Key Points

• Diversification is a big buzzword across investing circles, especially when advising new investors.

• The purpose of diversification is risk reduction. The fewer holdings in a portfolio opens up the risk of an individual company “blowing up”. When that is one of a few companies you are invested in that can cause a huge drag on your portfolio.

• There are multiple levels of diversification: company level, industry level, market cap level, geography and a multitude of others. 

• At Genvest we believe in diversification but not over-diversification. An investor does not need a portfolio of 50-100 stocks to be diversified. 

Don’t Put All Your Eggs In One Basket! The Benefits of Diversification

The main point of diversification is reducing your risk and this is why it is important for investors to understand. The more concentrated your portfolio is (the fewer holdings) the greater the risk and this could result in a higher reward but a wise investor should be cautious. With all of your assets tied up into 2 or 3 securities, a negative move in just one of them can derail you from your goals and kill your returns.

Diversification has multiple levels. For example if you are looking at just large cap U.S. stocks, diversification means investing in multiple sectors in order to diminish some of the single security risk that can end up in the portfolio. The question is how diversified do you need to be? 

For a younger investor with a long time horizon they can be less diversified and possibly own one or two stocks or an ETF / Mutual Fund in each sector(different parts of the economy like Technology, Healthcare, Financials, Consumer Staples, Communication Services etc.) 

But as you age and your risk tolerance decreases, it makes sense to own more securities or even invest in the index like the S&P 500.

A General Rule of Thumb is to never let a Single Holding become worth more than 10% of the value of an investor’s portfolio. By Holding this means an ETF, Mutual Fund, Individual Stock, and will go as far as not allowing a sector or industry to become too large of a percentage of the portfolio as well. 

For a sector or industry it is okay for it to be a little bit more than 10% of the portfolio but once it starts to hit 15-20% it might be time to start to consider trimming it down a bit.

In other words, do not let the portfolio become heavily concentrated in any way at all whether it be sector based like Technology, Financial Services, Healthcare, Emerging Markets Fund, or individual stocks like Apple, Lululemon etc etc..Remaining evenly weighted in a diversified fashion is key to risk reduction.

Visual Example To Help With This

An Investor has Holding A and B that have performed very well resulting in an increase in the value of their portfolio. Naturally, these two holdings will make up a larger weighted average in the portfolio due to their superior performance compared to the other holdings.

While A & B still might have attractive outlooks, it is important for the investor to consider reducing their exposure to them to mitigate portfolio risk(having all your eggs in one basket concept).

Since no individual holding should ever make up more than 10% of the value of the portfolio, the investor sells some of the shares and will hold the cash until another attractive investment opportunity presents itself or will reinvest into other holdings in the portfolio that they want to gain more exposure to because the market might be undervaluing them.

The result is bringing balance back to the portfolio and ensuring the holdings that performed very well are capped at 10% max after a successful run. Some will even argue that investors should aim for 5% especially once you get towards 20 holdings in the portfolio. 

This is the more ideal level of diversification but an investor does not need to know 20 companies to immediately invest into. Investing in a single name should happen after due diligence.  It will take time to get fully diversified when it comes to the active stock picker but it is something every investor needs to work towards.

What If I am Not Ready to Pick Stocks and ETFs? The S&P 500 Will DO

In general if you don’t fancy yourself an expert stock selector or which sector to invest in yet, it is likely the best approach is to purchase an index such as the S&P 500. 

Believe it or not, investing in just a S&P 500 index fund gives you full diversification across various sectors of the economy. Heck it is 500 companies at the end of the day. Actually it is a little bit more but you get it.  

On a much greater scale, the overall portfolio will be diversified not only across sectors but also across asset classes. You would likely own not only U.S. large cap stocks but also mid caps and small caps. You would like to invest in some international indices and perhaps even emerging markets. The portfolio might also include allocations to fixed income and alternative investments to bring down your overall level of risk. 

While it is important to build towards this, do not go out and just start picking names based on gut feelings, researching and ensuring you are getting a fair price is critical.

Conclusion

Put more simply, diversification is similar to having a star player on your team (let’s call them Amazon or Google) that needs to be supported by possibly less exciting but still functioning teammates (industrials, consumer staples, bonds and alternatives).  If your star player goes down you will still have others ready to step in and reduce the downside to your team (the portfolio).