How to Diversify Your Stock Portfolio

“Sow your seed in the morning, and at evening let your hands not be idle, for you do not know which will succeed, whether this or that, or whether both will do equally well.”

Ecclesiastes 11:6 (NIV)

In the biblical book of Ecclesiastes, King Solomon, considered to be one of the wisest biblical figures, shares his thoughts on how a man should best spend his time on earth. As he works through that issue, he counsels men to “sow your seed in the morning” and “at evening, let not your hands be idle.”

The logic behind his advice is that you don’t know which of the pursuits that you work toward will be successful, so work on something in the morning and work on something else in the evening. A modern way of saying the same thing is don’t put all your eggs in one basket. Solomon’s lesson is a lesson on diversification. It’s a lesson that applies in many areas of life, including investing.

Note: This blog addresses diversification of your stock portfolio and not your overall investment portfolio, which could include bonds, cash equivalents, real estate, cryptocurrency, and other alternative assets.

To diversify is to spread your investing dollars across more than one investment to reduce the risk of losing money.  In Solomon’s time, a farmer who sows his seeds in the morning might try his hand at managing an inn in the evening. If his seeds fail to produce, perhaps his hospitality business will take off. In our times, there are many ways to diversify investments. A simple way is to invest in multiple stocks. If one stock tanks, maybe the other will go to the moon, offsetting your losses.

Different Types of Risk

Since diversification is about reducing risk, it’s helpful to understand the different types of risk that investors face. There are two general types of risk when it comes to investing in the stock market: systematic risk and business-specific risk.

Systematic risk is the risk that affects the performance of most stocks. It’s risk that’s built into the business ecosystem. It includes factors such as war, inflation, and high interest rates. These factors can affect the value of all stocks.

Business-specific risk is the risk that is unique to a specific business. It includes events such as lawsuits, winning or losing major contracts, and the successful or unsuccessful launch of new products. Events such as these only affect the value of an individual company’s stock, not the whole market as with systematic risk.

Every investor has a portfolio of investments with varying degrees of diversification. The investor with a portfolio made up of only one stock has no diversification and is highly susceptible to business-specific risk. If the underlying business of the one stock portfolio faces a string of unsuccessful product launches, then the value of the portfolio could face a dramatic decline. The owner of the one stock portfolio could add more stocks to reduce the level of business-specific risk. If the value of one stock drops due to a negative business-specific event, it will be offset by the gain in the value of another stock due to a positive business-specific event.

Example:

Investor Jim feels optimistic about Company X. He decides to invest his entire portfolio, worth $10,000, in stocks of Company X. A few weeks later a report comes out that Company X’s main product contains a chemical that is toxic to pets. The value of the stock falls by 50% in one day! Half of Investor Jim’s portfolio has been wiped out by a business-specific event.

Investor Kim invested in Company X at the same time as Investor Jim. Unlike Jim, she decided to invest only half of her $10,000 portfolio into Company X stocks. She invested the rest into stocks of Company S, which produces emergency kits to treat pets for toxic chemicals. When news broke about the dangers of Company X’s products, Investor Kim also lost half of her $5,000 investment in Company X. On the other hand, her $5,000 investment in Company S increased by 60% on the news, covering her loss on Company X stock while netting a small profit. Her decision to diversify protected her from business-specific risk.

As an investor continues to add more stocks to their portfolio, business-specific risk can be reduced to practically nothing. The investor with that well-diversified portfolio still does face some risk, i.e., systematic risk. No matter how many stocks an investor adds to their portfolio, he or she can’t eliminate systematic risk.

So how many stocks does an investor need in their portfolio to eliminate business specific risk? Here is a textbook answer: “almost half of the risk inherent in an average individual stock can be eliminated if the stock is held in a reasonably well-diversified portfolio, which is one containing 40 or more stocks in a number of different industries.”1

The magic number is 40 stocks held in a variety of industries. The different industries you can pick stocks from include:

  • Energy
  • Materials
  • Industrials
  • Consumer Discretionary
  • Consumer Staples
  • Health Care
  • Financials
  • Information Technology
  • Telecommunication Services
  • Utilities
  • Real Estate

How to Diversify

You recognize the wisdom of Solomon and the textbook authors, but the question of how to pick the 40 stocks to hold in your portfolio remains. There is an easy way and a hard way.

A quick and easy way to diversify your portfolio is to invest in a market-index fund like the SPDR S&P 500 ETF (SPY). When you purchase a share of this fund, your investment is automatically diversified among the holdings of the S&P500 index, which contains 500 of the largest companies listed on US stock exchanges. If your stock portfolio consisted of only the above-named fund, it would be considered well-diversified. No further work would be necessary. To get an idea of the returns you could expect from this approach, SPY has grown 102% over the last five years (as of this writing in September 2021). $10,000 invested five years ago would have grown to $20,200.

The more difficult approach is to do the research to find 40 companies, across different industries, that are worthy of investment. An investor would have to conduct extensive fundamental and qualitative analysis of each business under consideration for investment. Alternatively, an investor could pay for access to an equity research service that provides in-depth business analysis. Equity reports should be read with a grain of salt as there is evidence that analysts can be overly optimistic.

Below is a snippet from a report on Netflix published by Credit Suisse in 2018.

excerpt from equity research report

For a good, brief overview of how to research stocks, I recommend What to Look For (and Avoid) in a Stock by Brew Cents Worth.

If you’ve chosen the more difficult approach and have completed the research, you still must decide what percentage of your portfolio you are going to invest in each stock. You could use a scientific approach like the efficient frontier. The efficient frontier gives you optimal combinations of your chosen stocks based on statistical measures of risk and return. The process is mathematically complex. Though the website is a little buggy, efficientfrontier.app can build optimal portfolios for you. Just input the ticker symbols of your chosen stocks, and it will suggest the percentage of your portfolio to invest in each stock. One critique of the efficient frontier method is that it uses historical measures of risk and return, and the past is not always the best predictor of the risks and returns of the future.

A more casual method for deciding how much of your portfolio to invest in each stock is to go with your own judgment. After doing research and getting a feel for the riskiness of each stock, invest the percentage of your portfolio that you feel comfortable with. The more confident you feel about the quality of a company, the higher the percentage of your portfolio you can invest in that company. Even if you do feel confident, it pays to lean on the conservative side; many investors have been ruined by overconfidence.

Neither the scientific nor casual approach for allocating percentages of your portfolio are necessarily better than the other.

Wrapping Up

A final note is that not everyone agrees about the number of stocks to hold in your portfolio. The textbook authors recommend at least 40 stocks. The Motley Fool, a well-known investment advice website, recommends 10-15 stocks for your stock portfolio. I’ve heard of experienced investors holding less than 10 stocks in their portfolios; they are confident, based on their extensive research, in the quality of the businesses they have chosen for investment. Your approach to diversification will depend on your experience and risk-tolerance. For most, the best approach is the easiest; diversify with a market-index fund. The general principle to remember is that the more stocks you add to your portfolio, the more protected you are against business-specific risk.

If I was giving advice to a friend, I would say go for an index fund if you don’t have much time for research. If you want to be an active investor, shoot for 10-15 stocks. More than that and you won’t be able to keep up with the research required to select quality stocks.

Disclaimer: This is not investment advice. I am not a financial advisor. I do not own any positions in any ETFs or stocks mentioned.

Endnotes

1. Eugene Brigham and Michael Ehrhardt, Financial Management: Theory and Practice 16e, (Cengage, 2019), 258, Kindle.

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