Diversification….how much really is enough?

Diversification is a staple principle for most investors.  The general idea is one of risk mitigation – or in other words, trying to avoid loosing your entire investment portfolio due to one bad investment decision. Most people think about diversification in terms of risk however very few consider the impact of return on the funds invested.   There is an important balancing act between the risk and reward elements.  If you hold too many positions then some of your greatest ideas generate very little return on your total invested capital.   For example lets say you have $100,000 of investable assets and each position is about 1% of the total portfolio exposure.  In this example each position would be around $1,000 each.  If one positions provides a strong return of say 50%.  The return on this one investment would be $500.  Now you may be very excited with this return, however it will only drive around 0.5% of total performance to your entire portfolio.   Hence, there is a fine line when it comes to investing.  It is important to think about not only diversifying your risk away but also at the same time diversifying your return away too.   The other problem with very diverse portfolios is one of investment ideas.  The more positions that you hold the more ideas which are worthy of including in the portfolio are required.   So in the example above, a person with the $1,000 exposure per position would need around 100.  This is compared to somebody that might hold just 19 positions whereby they can be more selective about what might include and what they might leave out.   Warren Buffet once stated “diversification is protection against ignorance, it makes little sense for those who know what they are doing.”  His portfolio via Berkshire Hathaway holds $117 million in 15 odd positions.  Yet you compare this to the typical managed fund which is labelled as “actively managing money” and they might hold up to 200 different positions at any one time.   So the question is how much do you really need to be diversified?  The statistical answer is around 19 positions.  If you hold 19 position you will be around 95% diversified.  Trying to chase the remaining 5% of diversification to reach the 100%, in essence, actually waters down the total underlying return of the portfolio – or as otherwise stated above, diversifies away your return.   Now it is important that when you look at these 19 positions that they are different.  For example you can’t hold 19 different mining stocks and say “look I am now diversified!”   You also need to consider your asset allocation in that you have exposure to different sectors such as cash, fixed interest, shares etc is important too.  Within in each sector you may also have further breakdowns in exposure, for example within shares you might hold a range of positions in different sectors.   It is important however, that you don’t hold a range of assets just for diversification sake.  I have seen too often people holdings exposures to assets classes which might have poor medium to long term prospects just for diversification reasons.  Equally, I have also seen people invest into sectors which have poor long term economic prospects just for diversification principles.  So, it is vital that each exposure provides meaningful returns, and if one can’t be found then you just wait until the opportunity presents itself.   If you want to find out more about how to fine tune your investment portfolio for risk and also return with the ideas discussed above, feel free to contact AJ Financial Planning for a no obligation free discussion.