arcinvest | Brisbane financial planner

Portfolio Management: Diversity

As long ago as when Benjamin Graham, the father of value investing and early influencer of Warren Buffet, was working on Wall Street developing his revolutionary economic theories, he identified and endorsed diversification as being key to good investment portfolio management.

This belief is fairly commonly held, everyone has heard the old adage, don’t put all your eggs in one basket, but exactly how many baskets should you have, how many eggs in each and what type of eggs?

How many shares should you hold in a portfolio?

Unfortunately, for those who seek simplicity and clarity, the answer, like most answers in investing and life, depends on a number of variables.

The simplest answer available is this:

The greater the number of stocks, the greater the diversity, and the lower the amount of overall portfolio risk.

Holding a single share is the same as putting all your eggs in one basket.

For example, if you invest only in Company A, you are at risk of 100% of Company A’s specific risks, such as internal fraud or product failure.

If you were to purchase additional stocks in Company B, your risk with Company A is immediately halved, as is your risk with Company B. 100% of your risk is now made up from 50% from Company A and 50% from Company B.

It is important to also understand that, while you have indeed doubled the number of associated risks (risks tied to a particular stock), you have lowered your overall portfolio risk, including the possibility of permanent loss of capital.

Each additional share you add will contribute to lowering your overall risk, however as you build up your collection of companies, each additional share will reduce the benefit of diversification achieved.

“Value” investors (investors working within a margin of safety and continually monitoring each business) will typically run a portfolio of around 10 to 15 shares. The aim is for any single share to have a maximum exposure of 15% of the portfolio, with ideally around 5 of them making up 7-10% each.

Diversity matters

It is also important to ensure you have a diverse spread of different industry sectors amongst the businesses you invest in.

Often opportunities for value come up within the same sector. For example, share prices for many mining contracting companies were well below valuation a few years ago. It is important to remember, however, that building your portfolio entirely from businesses within this sector is not true diversification. While you have diversified your companies specifically, you have not diversified away from that industry which faces similar economic and global risks.

Contact arcinvest for advice on how to achieve the optimal diversification within your investment portfolio.

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