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Reducing Risk Through Diversification

Course Section 2 - Lesson 4

In the last lesson, we discussed the idea of diversification to reduce risk. Diversification is a word that you hear a lot in the investment arena. It means to spread your bets so that a single event doesn't have catastrophic consequences for your entire portfolio. In this lesson, I want to take a deeper look at why we would engage in the practice and how we execute such a strategy.  

The Why of Diversification

After the last lesson, the why of diversification should be obvious - unexpected situations can quickly impair or even destroy companies and industries. By spreading the risk across multiple investments in our portfolio, we can insulate ourselves from the threat of bad luck striking a single stock decimating our portfolio.

Protecting against losses is essential, and, intuitively, losing money is not a good thing. But it may not be immediately apparent why this is so important.  

Investing is a game of compounding returns. If you are a young lad or lady saving for retirement, you may decide to put away $250 a month to help make future-you comfortable. If you were to stick that money in your mattress for 40 years, you would find that your bed had $120,000 in it on the day you retired. Pretty good, but probably not enough to last you through retirement. Alternatively, if you were to invest it and earned 8% per year, that same $250 monthly investment would turn into nearly $875,000. Much better.

The power of compounding leads directly into why protecting capital is so important. If your portfolio falls by 50%, you don't recover once it rises by 50%.  

To get back to square one, you now need your portfolio to rise by a full 100%. That math works that way for all losses. Declines in portfolio value require a more significant gain to get back to even. Because of this mathematical phenomenon, we as investors must protect ourselves against losses. At the individual stock level, we do this by doing fundamental research on the securities we purchase (more on this in lessons 3 and 4); at the portfolio level, we do this through diversification.

Diversifying Your Stock Portfolio

There is no question that diversification is the key to reducing company-specific risk. However, in practice, the implementation gets complicated. Questions like: 

  • How many stocks should you have in your portfolio before you are adequately protected? 

  • At what point does a portfolio become so diversified that the time-consuming research you have done to find the gems is diminished?

creep in and cause portfolio construction angst.

Luckily, research on the question has been done. Burton Malkiel found that by the time a portfolio reached 20 (randomly selected) securities, the total risk of the portfolio was roughly the same as the market as a whole. That number gives us a rough estimate of the number of securities we should seek to include when building our stock portfolio.  

Including fewer securities will your portfolio will expose you to unnecessary levels of company-specific risk.  

On the flip side, you don't necessarily gain anything additional by including more than ~20 stocks in your portfolio. In fact, you may actually hurt your investment returns by including mediocre investment ideas. When you are researching companies to include in your portfolio, you will be much more excited about your top two or three ideas than idea number 25. Remember, the balancing act we face is neutralizing company-specific risk while still ensuring that your best ideas represent sizable chunks of your portfolio. 

Dampening Industry Specific Risk

There is a big caveat associated with Malkiel's 20 stock rule. When he did his study, the stocks that he selected to gauge portfolio risk were completely random. That means that he likely didn't have to worry about an industry concentration building up in his hypothetical portfolio. You will. The 20 stock rule doesn't hold if your top 20 ideas are all social media companies. Such a portfolio would leave woefully exposed to industry-specific risks like those that wiped out the entire video rental industry in the previous lesson.

When your building your portfolio, work to construct it with companies from many industries. This will ensure that you don't end up with a portfolio that is susceptible to a lightning strike as the world evolves.

But I don't have 20 Stock Ideas

As a new investor, you likely won't have 20 stock ideas that you can immediately put to work in your investment portfolio. Heck, even as a seasoned investor, there were many times where I was unable to build a stock portfolio to a level of diversification that I was comfortable with.

There is a solution to remain properly insulated from industry and company-specific bombs detonating and ruining your portfolio in this scenario. The trick is to realize that if you target a 20 stock portfolio, then on average, you will be investing 5% of your capital in each company. To ensure you don't become overexposed to any one company, limit each investment you make to only 5% of the cash you have available for investing.

For example, if you currently have $500, that means each purchase you make should be approximately $500 x 5% or $25. The $25 position size is what you should target, even if you only have 3 or 4 stock ideas that you are ready to invest in.  

Your Custom Competition Portfolio

So you have made your first four purchases. That's great! But now you have a new problem. You've only invested $100 of your $500 portfolio. What do you do with the remaining $400?

The first thing that you need to realize is that sitting in cash is ok. You don't need to feel pressure to be fully invested all of the time. However, if you do want to be fully invested, you have options for that as well.  

When you are out of stock ideas but want to have your capital "at work, " you seek market exposure. Today, we have some fantastic options available to provide inexpensive market exposure to investors. The way you achieve this is through stock index ETF's.

Continuing with the example above, if you've invested $100 of your $500 portfolio in individual stocks and want the remaining $400 to be invested, you could purchase $400 of an S&P 500 index ETF. Such an investment would give you exposure to all 500 stocks in that index along with proper industry diversification.

As you identify new stock ideas down the road, you could simply sell $25 chucks of your index exposure to give you the proceeds you need to fund new stock purchases.

This strategy allows you to stay fully invested while you are doing the work necessary to identify individual companies and stocks that will eventually fill out your portfolio.

Mark Complete