Diversification is a tool for managing risk. If, for instance, you have one stock in your portfolio, you incur the risk that if your investment in that stock is a mistake, your entire portfolio will suffer. The risk from that stock may be for reasons other than your error. That stock’s price may fall because market conditions in its sector deteriorate. There are any number of reasons why a stock’s share price may fall. As you add stocks to your portfolio, you reduce the risks from any one investment. You need to spread your bets. This notion has been around since the dawn of time. You can see it in the saying, “Don’t Put all your Eggs in One Basket”, in sayings in the Talmud and other injunctions to spread your bets. Apart from reducing the The question for you then is how do you diversify your portfolio?
Diversifying a portfolio means that your portfolio can survive through various market cycles. Say for instance you have a stock that does well in bear markets and a stock in a sector associated with bull markets. A portfolio like that has a stock that will do well during a bull market and when the bull market ends and the economy enters a bear market, it has a stock that can pick up the slack. That’s a crude way of explaining how diversification allows your portfolio to keep performing under different market climates.
One of the least utilised ways to diversify a portfolio is geographically. Indeed, it is one of the great puzzles of finance that people exhibit a high degree of home bias. Even when you are invested in stocks that do well in different market conditions in a country, all those stocks are correlated to a high degree. This is because all businesses within an economy are influenced by the same money-market conditions and other broad market conditions. There is a limit to how uncorrelated the stocks will be. However, you have more of a chance of achieving the aims of diversification if your portfolio is international. It’s true that in a global economy, markets are highly correlated, but, investing along international lines is more reliable than investing within a single economy. Diversification is a bit like providing segregated storage because it reduces the risks from any given stock. What better way to achieve this than by going international?
Focus Your Bets
There are limits to diversification. Research shows that after the 20th stocks, the gains from diversification decline. So, you want to have a portfolio of not more than 20 stocks. At a time of passive investing and portfolios with hundreds of stocks, this suggests a very concentrated portfolio.Now, does this mean that each stock has an equal share of your portfolio? No. Those investors who use focused portfolios tend to use the Kelly criterion to size their bets. The Kelly criterion is a way to size your bets according to their likelihood of maximizing your returns. Using the Kelly criterion leads to very large positions when the data says that you should have high conviction about a stock’s potential. For instance, Apple makes up 43% of Warren Buffett’s portfolio. This is despite the fact that Buffett’s portfolio is well-diversified.