As the old saying goes, the only free lunch in investing is diversification. One of the best things an investor can do is to diversify their holdings across different sectors to minimize risk.
I’m not telling you anything new. In fact, just about every one of you knows that diversification is important. But how far should an investor go? Besides diversification across equities in various sectors, an investor has to think about other asset classes such as debt, real estate, commodities or derivatives. If you’re feeling particularly frisky, you could even invest in collectables, art or wine. There are countless ways to diversify one’s portfolio and there simply isn’t enough time to fully research them all. What’s an investor to do?
Stocks are simple to diversify. All you would need to do is invest your equity positions in various broad market ETFs that track exchanges like the S&P 500 or the Russell 2000. If you’re someone who invests in individual stocks, diversifying is a little tougher, but can be easily done given a bit of time and some research.
The question is just how far one needs to go to obtain an adequate amount of diversification. How many equity positions is enough? 15? 25? 50? Even more? The guys at Contra the Heard try not to have any more than 25 names in their portfolio, often having less than 20 companies they’ve invested in for the newsletter. Most mutual funds will have positions in over 100 individual companies. While diversification is somewhat of a personal decision, it is very possible to be over diversified.
Just about everyone has too much of their net worth tied up in one “asset”- their house. If the value of their home goes down any amount of value, their net worth is affected greatly. Yet many people spend their entire lives investing primarily in one thing, like real estate, and do just fine. They have too much of their net worth in one asset class and yet end up with a substantial net worth. Are these people doing things wrong? Or are they simply putting all their eggs in one basket that they observe constantly and know like the back of their hand?
While I believe every investor should diversify, the question about how much they should is best answered individually. If somebody doesn’t fully understand certain asset classes, should they really be putting hard earned cash into that type of asset? And if you’re really good at investing in one asset class, then is moving into other types of investments really that good of an idea?
My dad is really good at investing in real estate. He’s built most of his net worth from buying rental houses. If you were to look at his balance sheet, he would have a large percentage of his net worth in real estate. From a traditional diversification perspective, he’s woefully undiversified. Yet this strategy has worked out extremely well for him. What’s an investor to do?
This is one of those things that is an individual choice. Some people are very good at putting all their eggs in one basket and doing a terrific job with that basket. Others need to diversify among many different asset classes because of a fear of missing out on one of them. Whatever people choose, we can all agree that having a large part of their net worth in one stock or their principal residence isn’t the best course of action.