Diversification

Diversification

Intuitively most people can see the advantage of holding a diversified group of stocks as opposed to holding just one or two. Because randomness plays just a huge role in investing, most investors realize the need to spread their risk in order to avoid bad luck or bad judgement on their part. The problem is the financial industry has taken the concept of diversification and used it as an intimidating weapon to club their customers into submission for their own benefit.

Even if you took the precaution of buying and owning all the stocks in all the indexes (9,000?), you would still be at risk for the up and down movement of the entire market. This risk, known as market risk, would not have been eliminated by your “perfect” diversification

While simply buying more stocks can’t help you avoid market risk, it can help you avoid another kind of risk …“non-market risk”. Nonmarket risk is the portion of a stock’s risk that is not related to the stock market’s overall movements. This type of risk can arise when a company’s factory burns down or when a new product doesn’t sell as well as expected. By not placing all your eggs in one basket, you can diversify away that portion of your risk that comes from the misfortunes of any individual company.

Statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is further reduced by 72 percent with a four stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks, 96 percent with 32 stocks, and 99 percent with 500 stocks.

Points to remember concerning diversification

-          After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.

-          Overall market risk will not be eliminated merely by adding more stocks to your portfolio.

To properly diversify one should put his money in other asset classes like your home, gold if you like, bonds, life insurance policies and my personal favourite…hard cold cash…The cash I hold in my bank account allows me to ride out the volatility of my stock holdings in my RRSP. 

Resources

You Can be a Stock Market Genius

Joel Greenblatt