Why You Should Diversify Your Investments

Do you ever get that sinking feeling when you read the news and find one of your shares has just tanked? We all do and we simply can’t avoid the possibility — in fact, it’s pretty much an inevitable occurrence sometime in everyone’s investing career.

We can mitigate the risk by not putting all our eggs in one basket and instead, by keeping a diversified portfolio. If a company that crashes accounts for 50% of your stock market investments, you’ll suffer a lot more pain than if it’s just one stock out of 10 or 15 or so.

But if you ‘diversify’ through buying shares in 10 different companies in the same sector (for example oil exploration), then you can still be in deep trouble if the sector suffers a calamity. The answer, of course, is to spread your cash across companies in different sectors.

Easy enough?

That sounds simple, but there are some easy mistakes that people regularly make, and the biggest is to over-diversify (or ‘di-worse-ify’ as some people call it). The problem is, the more you diversify the lower the incremental benefit gets. Your second share will make a big difference to your safety, but the 10th a lot less.

It’s been academically tested too. Two researchers in the 70s by the names of Edwin Elton and Martin Gruber measured what’s called the “standard deviation” of annual portfolio returns depending on the number of individual investments they held.

By the time the 10th share is added, they found there’s really not much benefit, by 20 shares even less, and by 30 shares there’s pretty much no benefit at all. In fact, by that stage you’re very unlikely to do better than an index tracker, so you might as well just get one of those instead and save on the effort.

Don’t buy junk

Another mistake comes from buying a poor share just for the sake of diversification. You might have, say, shares in 10 companies that you really like but end up buying several more in which you have less confidence just to make up the numbers. And that very much goes against the core Foolish principle of understanding what you’re investing in and only buying shares that genuinely satisfy your investment criteria.

So what’s the best number of shares to hold for diversification purposes? I’d say it depends on your approach to risk. If you don’t mind a bit of risk, then five or so shares from diverse sectors will make a significant contribution to safety. But if you’re really averse to risk, then I think around 15 stocks really is about the most you’d need.

Portfolio

But what should you buy for a diversified portfolio? That depends on your strategy, but to start I might suggest a bank like Lloyds Banking Group, an out-and-out dividend share like National Grid or SSE, an investment in oil like BP or Royal Dutch Shell,  a long-term pharmaceuticals prospect like GlaxoSmithKline or AstraZeneca, and (seeing as I don’t mind a bit of risk) a strong growth candidate like ARM Holdings.

To take it towards 10, perhaps a solid insurer like Aviva and a global household goods maker like Unilever, but then I’d be struggling on the diversification front because I prefer to choose shares on their own merits in isolation rather than on what diversity they might provide.