Diversification without diworsification

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Chocolate, chips and cakes are all good in small doses. However, too much of a good thing can be dangerous — for your waistline at the very least.

What's true for junk food is also true for diversification. Small amounts of each can be beneficial, but go too far and you'll wind up feeling bloated.

A recent Take Stock newsletter inspired Eva to ask the following question about portfolio construction.

Do you recommend a max number of shares a person should hold in their portfolio? Over the years I have accumulated about eleven, a few I have got from companies splitting up etc. But now as a dedicated Fool reader I wish to acquire some of your suggestions. Please help; can someone have too many small holdings?

The short answer to Eva's question is there is no right number of companies to hold in a portfolio. But keep reading, as there is a right number for you. By the end of this article I hope you have enough information to know why you should diversify and what the right number of companies is for you.

How many is enough
We believe in building a diversified portfolio, much like Walter Schloss, who generated astounding annual returns during his lifetime and held nearly 1,000 securities.

We need not own that many shares, but a diversified portfolio protects us from the inevitable sharemarket blips — and allows us to sleep well at night.

As the following chart shows, diversification  can be achieved with as few as eight shares, and its benefit is generally exhausted by the time a portfolio contains 30 shares. The maximum number of companies an individual investor should own is around 50, though most investors should stick to under 30 companies. But remember, as Walter Schloss demonstrated, there is no right answer to the maximum number.

While diversification is good for some portfolios, it can be wrong for others. The trick is to learn how to properly diversify for your situation and tolerance to risk. Avoiding an oversimplified approach to spreading investments thinly gives investors a better chance to beat the market.

Concentrate to accumulate, diversify to protect.
For a retiree living off their investments, diversification is a great idea. But a young investor aiming to trounce the market, may be best served by concentrating their investments as wide diversification is the surest way to guarantee average performance.

So retirees, who also have more time to monitor their investments, should consider 30 or more shares, while young investors aiming to shoot the lights out should own less than 20.

To paraphrase Buffett. The stock market is a no-called-strike game. You don't have to swing at everything — you can wait for your pitch.

The more you swing your bat the more likely you'll achieve average returns. Each swing forms a tiny part of diversification, and diversification is the surest way to achieve average returns. Not that there is anything wrong with average returns.

Peter Lynch coined the phrase diworsification in the investing classic One Up On Wall Street. Lynch was referring to companies who attempted to diversify their business, but in doing so dragged down their overall returns. Individual investors can make the same mistake.

The best way to guard against diworsification is to compare potential additions to your portfolio to your existing holdings. If the new company does not stack up against existing holding then it should not be included.

Pulling out the flowers
I'll turn to Lynch again for another mistake investors can make in the name of diversification. One of the biggest mistakes investors make is cutting back on their winners that have grown to a large portion of their portfolio. This re-balancing can actually take money out of your best stocks and spread it in more mediocre places. As Lynch said that's pulling out your flowers and watering your weeds.

Think about the risk you own
While it may seem obvious that you should diversify to mitigate risks, many investors focus too much on the number of companies they hold, rather than the risks they hold. Perhaps I too am guilty of focusing too heavily on the numbers in this article. So let's address that.

Investors should diversify to remove what are called diversifiable risks. That is, risks unique to individual companies, industries, asset classes and so on. Rather than think about the number of companies you own it is better to think about the risks you own.

As hedge fund manager John Paulson found out this year with his oversized bets on the banking sector, it doesn't matter how many companies you own, if your investments are all exposed to the same risks you may get bitten on the butt.

For example, a portfolio of ANZ Banking Group Limited (ASX:ANZ), Westpac Banking Corporation (ASX:WBC), BHP Billiton Ltd. (ASX:BHP) and Rio Tinto Ltd. (ASX:RIO) is exposed to similar risks. All four companies are exposed to a European collapses and/or China slow-down.

The trick is find companies that have different risks. For example if you replaced ANZ with Telstra Corporation Limited (ASX:TLS), you've started to diversify your risks. Though remember you're not removing risk, you're simply swapping one set of risks for another. The trick is to find risks that won't all come home to roost at once.

Foolish Bottom-line
Having a well-diversified portfolio will help you avoid some of the biggest bumps the financial markets throw your way and will let you sleep better at night. Remember, though, that you can't remove market risk and the calming impact of diversification works both ways — which will sometimes leave you disappointed.

Are you looking for more quality stock ideas to diversify your portfolio? Motley Fool  readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

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