Many investors get excited about a single stock because they love the story behind the company. With a concentrated position in one great stock, if all goes well, you can increase your wealth big times. But it can also carry a tremendous amount of risk. If something goes wrong the stock can drop and make your overall wealth going south. That’s a recipe for disaster when you need money at this point or you go into retirement. From a risk point of view, heavy concentration in a single stock is the biggest mistake you can do.
Do not underestimate the importance of diversification, when it comes to investing. Here are some important points about diversification:
1. The more stocks you owe, you eliminate the stock specific risk. The less specific risk you have of any one stock, the leass risk you carry that one day this stock is blowing up and hurting your overall wealth or retirement.
The value of your portfolio will still fluctuate when shares trade higher or lower. But your stock-specific risk will decrease every time you add a new position.
2. We also have to think about how many stocks we can research and know enough about to properly invest in them. The vast amount of research it takes to know all of your positions well enough, could be overwhelming. There’s a point where owning too many stocks can be counterproductive.
If you’re just adding more stocks without really researching which stocks are the best for your retirement, you may just be diluting your returns with too many marginal positions.
3. If you own 8 different stocks in your portfolio, you’ll reduce about 81% of the individual stock risk and if you own 32 different stocks, you’ll eliminate 96%. That means that you’re protected from the risk of one single stock and at some point, adding another position to your portfolio doesn’t really give you any additional benefit from diversification.
4. Make sure you’re spreading your investments into several different stocks. Ideally between at least 10 and not more than about 30. Once you reach 30 it’s probably best to only add another stock if it’s better than one of your existing positions. Exchange the new for the worse position.
5. Make sure that the different stocks that you own are from different areas of the market. Do not owe 10 high-tech companies, because you’re still taking on all of the risk for that particular industry. It is not smart because there are plenty of opportunities to grow your wealth and generate great income from many different areas of the market.
Sven Franssen