The Motley Fool

Why Is Portfolio Diversification Important? A Beginner’s Guide To Investing – #AskAFool Video

“Why is diversification important when it comes to investing?” We hear this question a lot from people who are in the early stages of learning about investing. It’s a perfectly valid question, so we put it to members of our investing team to discuss.

VIDEO TRANSCRIPT

RYAN: Scott, how many shares should you invest in?

SCOTT: Oh, man, that’s such a good question. So you’re talking about individual companies here.

There’s an academic answer and it’s probably the best place to start. And the academic data seems to be updated reasonably regularly.

The current thinking is between 15 and 30 companies is the minimum number to get the maximum benefit of diversification.

Now, diversification doesn’t mean two of everything, the old Noah’s Ark approach.

Diversification is managing at a spectrum of risk factors across your portfolio. And well, some of it’s exposed to Australian housing, some of it’s exposed to information technology, some of it’s exposed to American manufacturing in ways that change the industry, the geography, the currency, the types of risks, the types of potential returns that are in your portfolio.

And the economic research suggests that between 15 and 30 is the right number to maximise the value of that diversification.

Now, again, it’s really important, so 15 banks or 15 retailers is not diversification. So, it’s not just the number of companies, but it’s the spread of those companies. are broadly representative of the market is the way you maximise the benefit of that diversification.

Just be very, very careful you don’t own 10 retailers, that’s not diversification, that’s just a collection of the same sorts of assets.

So, 15 to 30 is the right number for most people. Generally speaking, we say at The Motley Fool, get to 15 companies as quickly as you possibly can, because if you own one company, if it goes up 50%, you think you’re a genius. If it falls 50%, you’re probably going to be discouraged, put off, you’re not going to want to invest. So, there’s a question of how many, there’s also a question of how quickly. And we still say, get to 15 as quickly as you possibly can, just to make sure your portfolio is A, diversified, and B, not necessarily as subject to the movements of the market, the ebbs and flows, the shocks of both pessimism and optimism when it comes to investing.

You want to have a more stable, secure, diversified portfolio.

RYAN: Is there such a thing as owning too many shares?

SCOTT: There is if you can’t, well two reasons, if you can’t keep track of them. If I own 80 companies, I mean we do this for a job, I couldn’t keep track of 80 companies in my portfolio if I tried. I just, I physically can’t keep across in detail that many companies. So, that’s one reason what might be too many.

If you’ve got some individual services like our services that give you advice on all of those companies, that can be okay. But if you’re relying on your own ability, time, effort, to keep in touch, too many companies,more companies than you can keep track of is too many.

The other thing I would say is be very careful about where you want to put your money.

If you’re putting money in your 101st best idea, there’s every chance that you’re bypassing a whole lot of better ideas. So, by the time I get to 35, 35, 40 companies, you’re kind of saying, well hang on, if this is my best idea, the other 30 I own are by definition not my best idea, and you start to diversify almost to mediocrity. So, the right number is not too many that you can’t keep track, and not so many that you’re putting money into your 15th to 100th worst idea, you’re concentrating your cash to some degree, not to be too concentrated, but you’re always going to be investing in your best idea at any point in time.

RYAN: And last question. Do you think owning too many can therefore impact your overall returns or the potential of your returns?

SCOTT: Yeah, yeah, absolutely. And that’s what I mean about diversifying to mediocrity. You end up effectively getting a market return, maybe even worse if you’re not paying too much attention.

So yeah, you want to be able to concentrate your attention on a diversified portfolio, if I can use both of those terms interchangeably.

RYAN: So making sure that you have enough diversification, but not too much, somewhere in the range of 15 to 30 stocks.

SCOTT: You said it much better than I did.

RYAN: Excellent, thanks Scott.

SCOTT: Thanks Ryan.