Diversification

Outperform the market

Portfolio diversification is about how you minimise your exposure to risk. If one company performs poorly or fails completely, the fact that you are invested in other stocks means you won’t lose everything. However, investment in too many stocks could result in a potential under-achievement of market rates of return.

In order to build a strong, balanced portfolio of stocks that will outperform the market, you must be selective about the stocks you choose.

Example:

Let’s assume your portfolio consists of 100 different stocks. Each stock accounts for 1% of your total invested capital. To increase your returns by 1%, one stock will have to double in price. To achieve an 11% increase (assuming you are receiving 2% p.a. from dividends), nine stocks must double in price: (9 stocks x 1%) + 2% = 11%.

Another way is to focus your portfolio: for instance, 20 stocks, each representing 5% of your total allocation to stocks. Assuming the same 2% annual gain from dividends, only two stocks will need to double for you to exceed that 11% of the 100 stock strategy above:(2 stocks x 5%) + 2% = 12%.

A balancing act

Like all things in life, your portfolio needs balance.

You want to diversify enough to limit your exposure to risk, but concentrate enough to ensure that your shares bring you a return. The best diversification strategy has between 20 and 30 stocks in the portfolio.

You want to limit correlation as much as you can, so stocks should not be related to each other – different industries are a good start. For example, do not invest in Apple (AAPL) together with Samsung (SSNLF) and Foxconn (2354:Taiwan), as these are competitors or suppliers.

Balancing Act

Key principles

Here are seven key diversification points to watch out for:

  1. Between 20 and 30 stocks is ideal.
  2. Invest at least 2% of your capital in one stock; less than that will not give you the potential gains you want.
  3. Limit your capital investment in any stock to 5%, because this will limit your risk.
  4. Work up to 5%; do not start with it.
  5. The 2%-5% rule applies to the initial investment and its completion; the amount may fluctuate between these points at different times.
  6. Avoid companies in the same industry to enhance diversification.
  7. Do not increase an investment in advanced trends.

Conclusion

Select a concentrated number of stocks in order to limit your risk and maximise your potential returns.

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