Saturday, September 1, 2012

Diversification

I've never discussed diversification on this blog before, at least not to a major degree. I did allude to it in my recent post updating my portfolio. I'm not here to preach or educate anyone, I'm here to share ideas and learn from other investors. I really believe that the level of diversification an individual investor needs varies based on objectives, time horizon, risk profile and what you're comfortable investing in.

First off, let's define diversification. According to Investopedia, diversification is defined as follows:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
 

So, this defines diversification to a basic degree. You can diversify between companies, sectors and countries in order to limit risk and stem losses in a market slide. It's a fine line to walk, however, as you can over-diversify to the point of limiting gains. 

 My personal thoughts on diversification revolves around owning two or three very strong companies in as many sectors as I can afford and find attractive. In oil I like Exxon Mobil and Chevron. I own both, and just so happen to own Total for a little foreign exposure. I think Sysco is the best foodservice distributor in America. I own a piece of that business, and feel good about it, even in the face of declining profits with higher input costs. You can see where I'm going here. Take a sector and when you start narrowing it down to who is on dividend champion/achiever lists, who is profitable, who has an economic moat and who is the leader in that particular sector you start to see a very small list. Those companies are where my attention, and therefore my money, usually end up.

How many companies should you own? There is no right answer. A lot of it will revolve around how much money with which you invest. I typically invest $1,000-$1,400 a month and usually just purchase stock in one company with that amount. If I try to split that into two transactions broker fees typically eat into potential future profits.

In my opinion, the best way to figure how much diversification is necessary is to try and weight your holdings so that no one company has more than a 15% weight in your portfolio. In my particular portfolio, the Freedom Fund, Johnson and Johnson makes up 14.4% of my total investments. That is pretty close to as high as I'd like any one company to be and will probably shy away from buying any more right now. I'd be ok with temporarily going over 15% with one company if I felt it was of particular value. There are no hard rules with investing. You have to find your own comfort zone and go with it.

Although I feel there is no right amount of diversification, I do believe one can diversify too much and enter the "diworsification" territory that Peter Lynch famously coined. This is when you diversify to the point of maximizing safety and mitigate any potential gains. If your goal is to "buy the market" you are probably best served buying index funds instead of trying to buy so many companies that your potential gains are probably minimized. 

In the end, only you can answer the diversification dilemma for yourself. I think if you base it on how much money you have to invest with and try to weight your investments appropriately you will arrive at a level of diversification that is customized to your individual approach. 

When I'm all done with buying investments and I reach the point where I'm living on my dividends, I plan on owning 25-30 companies in 7-8 different sectors. I think that's an appropriate amount of diversification to minimize risk and maximize gains.

What's your level of diversification?

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