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The challenge of diversification on the ASX

Diversification in investing is a great tool for reducing risk and something all investors should prioritise. However, a large amount of diversification can also reduce the rate of return that an investor is able to achieve. This can make the decision about how much to diversify a dilemma for some investors.

An investor with a high-risk tolerance might choose to own a concentrated portfolio of ASX shares. Investors with a lower risk tolerance might choose to own shares in an index fund like the Vanguard Australian Shares Index ETF (ASX: VAS). This is a lower risk, more diversified approach to investing.

The advantage of less diversification

A well-diversified portfolio is less risky compared to a portfolio of only a few stocks as the investor is less exposed to the performance of each individual share. However, the potential return that can be achieved from a well-diversified portfolio is also lower, as the returns from the top performing shares are weighed down by the returns of the shares that haven’t performed as well.

For example, an investor who bought Afterpay Touch Group Ltd (ASX: APT) shares 1 year ago would have achieved a level of return above 88%. Had they also bought an equal value worth of Challenger Ltd (ASX: CGF) shares, a share which returned -35%, their total investment return would have been reduced to 53%. A clear example of how diversification can hurt the upside of an investment.

The risks associated with lower levels of diversification

The above example could also be flipped to show the perils of avoiding diversification. Had an investor only purchased Challenger shares, their investment return would have been -35%, far less than the 53% achieved by an owning an equal amount of both shares. There’s no doubt that -35% is a terrible result, but it’s not as bad as losing everything, which is also a possibility when investing with very limited diversification.

Foolish takeaway

By reducing diversification and creating a more concentrated portfolio an investor may achieve a higher rate of return. However, to achieve this, the investor is still required to pick shares that will perform well over the long term and must be willing to accept a higher level of risk.

I believe the ideal portfolio size is around 10 shares. Buying shares simply for diversification purposes is not sensible but neither is putting all your eggs in one basket. Investing more heavily in shares which you believe have the best chance of success makes sense, but the risks associated with this approach should be considered.

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Mitchell Perry has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of AFTERPAY T FPO. The Motley Fool Australia owns shares of and has recommended Challenger Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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