What is the optimal diversification for your portfolio?

Diversification is a strategy that investors may use to reduce risk in their portfolio. This is achieved by holding stocks in different sectors and different market caps.  However, you can overdiversify and this can affect the performance of the portfolio. In this article we talk about the dangers of overdiversification and what the optimal number of shares is for a portfolio.

Optimal Number of Shares for Diversification

Twenty stocks is the optimal number to have in a share portfolio. Your risk is reduced to about 29.2% with a portfolio of 20 stocks. Any additional stocks over 20 only reduces your portfolio risk by 0.8%, and this small benefit can be offset by the effort in trying to manage a high number of stocks.

Benefits of Diversification

Diversification is important to have in a portfolio as it can reduce risk by having exposure to different stocks in different sectors. Hence if one sector starts to perform negatively then having another stock in a sector which is performing well can offset these losses. Being too concentrated in one sector can become too risky as too much of your capital is invested in that sector. If there is a downturn in that sector, and you don’t act on it, then your capital is vulnerable as well.

Diversification can also apply to company size as well as company sectors. Smaller companies tend to be riskier than biggest companies but they can also generate a higher return. A diversified portfolio would hold a mixture of small cap stocks as well as large cap stocks. Therefore, if the small cap sector takes a hit, the investor will still hold large cap stocks to offset the losses of the small cap holdings.

Diversification also offers the investor different trading strategies. For example, an investor may decide they want to hold some stocks which can provide income so they buy dividend stocks but they also want to hold stocks that provide capital gain so they buy stocks which can provide that.

Risks of Overdiversification

Overdiversification can affect your performance. Holding more than 20 stocks does not reduce the portfolio risk anymore but can reduce the performance. Overdiversified portfolios may struggle to outperform the market indexes.

It is more difficult for the investor to keep track of announcements and stock performance if they more than the optimal recommended number. If portfolios are smaller, then investors can focus and watch a smaller number of stocks and trade more effectively.

Ideally, an investor will have less stocks, but in the sectors which are doing well. If they are active, they can then rotate from the weak stocks to the strongest ones to ensure that there aren’t too many weak stocks detracting from the overall portfolio performance.

Lauren Hua is a private client adviser at Fairmont Equities.

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