Getting Diversification Right -- The 90% Solution
Many investors unwittingly ruin their chances at meeting their investment goals by owning too many stocks. Diversification is a great concept, but only when used correctly.
Economics professors often teach the concept of "guns and butter." In times of peace, one wants to invest in butter. In times of war, guns are preferred. These two investments complement each other and, as such, have negative correlation. Negative correlation is a good thing. When one stock goes down, you can hope to lay off your bet by owning another which goes up.
Smart investors (professional or individual) would never be so bold as to believe they know where the markets are heading. It is wise to hedge bets.
So, how many stocks do you need to own?
Research says that you get 90 percent of the diversification benefits from portfolios consisting of 12-18 stocks, and after that you get diminishing returns.^1
And remember, there are fewer stocks for you to obsess over. Too much diversification may often result in mediocre returns.
So what is an investor to do?
- 1. Get to know the companies you invest in. Buy what you know, and remember that you are an investor -- not a gambler.
- 2. Keep track of your company. Every public company has an investor relations website with recent presentations. These provide a great summary of what a company does and recent news on that company.
- 3. Give a company some time to reflect the reason you bought it in the first place. Investing is not an overnight game. If you bought a stock because it has a superior widget or a technique for producing that widget, give it a chance. Nothing happens overnight.
George Young is the co- portfolio manager of the Villere Balanced Fund (VILLX), based in New Orleans. The fund received a 5 star Overall Morningstar Rating among 771 Moderate Allocation Funds for the period ending 9/30/2012 (derived from a weighted average of the fund’s three-, five- and ten-year risk adjusted return measure, if applicable) . The fund ranked in the top 2% for 1-year among 892 funds, 1% for 3-years among 771 funds, 1% for 5-years among 670 funds and 1% for 10-years among 381 funds in the Moderate Allocation category based on total returns for the period ending 9/30/2012.
1. Frank Reilly and Keith Brown, Investment Analysis and Portfolio Management
(South-Western Cengage Learning, 2012)
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