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Portfolio: Is Yours Diversified or Over-Diversified?


We've all heard the financial experts expound on the benefits of diversification, and it's not just talk; a personal stock portfolio must be diversified to some degree. After all, none of us wishes to "put all our eggs in one basket" and expose ourselves to the risk of a one-stock mass destruction. But, how far should we go in spreading our risk?


What is diversification?
When we talk about diversification in a stock portfolio, we're referring to the attempt by the investor to reduce exposure to risk by investing in various companies across different sectors, industries or even countries. Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works, but to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility. This is because different industries and sectors don't move up and down at the same time or at the same rate - if you mix things up in your portfolio, you're less likely to experience major drops, because when some sectors experience tough times, others may be thriving. This provides for a more consistent overall portfolio performance.

Is your portfolio diversified or over-diversified?
Diversification is like ice-cream: it's good, but only in reasonable quantities. As mentioned previously on the post "A Clean-Cut Portfolio", a reasonable range will be anywhere between 5 to 20 stocks, for easy and quick monitoring. As a good gauge, try not to have a list of stocks that run more than 1 Page of a CDP Statement. If you have more than 20 stocks in your portfolio, chances are that a number of the stocks are penny stocks that you may have found difficulty to exit, while you still need to keep a lookout for corporate actions (eg. rights or warrants issue) to take some money back. Work towards making a decision to cut and consolidate them into a good stock. According to Warren Buffett: "wide diversification is only required when investors do not understand what they are doing". In other words, if you diversify too much, you might not lose much, but you won't gain much either.
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