Diversification is a common mention when talking about investing. Holding just one stock, no matter how good the company is, is risky in case something really bad happens with the company. However, there is a lot more to diversification than just picking a bunch of different stocks. Having the right amount of stocks is also critical, because there comes a point where having more just doesn’t really mean much anymore. Knowing how to diversify you portfolio across sectors and the beta of stocks will protect you all different types of random market swings.
Where The Theory Comes From
In 1990, three men won a Nobel Peace Prize for their work in discovering how your portfolio and its risk correlates to the movement of the market. They found that as you added more stocks to your portfolio, the risk of it moved negatively exponential in relation. Shown in the figure below, William Sharpe, Harry Markowitz, and Merton Miller discovered that at 40 different positions in a portfolio, an investor has diminished risk. Although, after 40, the amount of risk you are diminishing does not change much.
In the analysis, the three economists used one of the Greeks called Beta, which measures how much a stock moves in relation to a whole market movement. When they say “the market” they are considering indexes such as the S&P 500 or the Dow Jones. If a stock moves higher in comparison to the market, it will be given a beta higher than one. If it moves less than the market, it’s beta will be less than one. High beta stocks are deemed as riskier however they have higher potential returns.
Which Stocks Should You Pick
You should first pick stocks based on the sector they are in. If you have a lot of confidence in the future of the electric vehicle market, you should look at Tesla ($TSLA), Nio ($NIO), or Workhorse ($WKHS). If you think the Big Tech will never die down, you should have Apple ($AAPL) or Microsoft ($MSFT). What sectors you have should be diversified. On the average day, if one Big Tech stock is down, they are all down. Stocks in the same sector have a high correlation, meaning even if you have 10 different pharmaceutical stocks, you aren’t actually diversified. Everyday they are moving the same, so if you are down on one you are down on all.
By this logic, you should have a few sectors you like and 2-3 stocks in that sector, and maybe a couple random stocks after that. Perhaps you don’t really like the future of the banking industry anymore, but you got J.P. Morgan at a great price years ago. Just because it doesn’t fit in your target sectors doesn’t mean you have to sell. Using our previous posts, find the exact stocks in the sector you feel you can trust and have a plan for the future when finding how to diversify your portfolio.
Risk Is Not a Bad Thing
In my opinion, if you are looking for true, risk-free assets, the stock market is not the place for you. No matter how safe you are, you can never avoid occurrences in the market like when the pandemic first hit in March 2020, or when Greece’s debt situation brought rumblings in 2011. Catastrophic events like this will always happen, but as long as you don’t panic and have cash ready to buy, you will come out stronger. You do not have to be a risk seeker, (although this brings the most gains) you can easily just be risk-averse. This kind of investor doesn’t take risks unless they see a reward from the risk. You might miss out on some big gains from being risky, but you definitely won’t lose from a foolish move when you know how to diversify your portfolio effectively.