Principles of Stock Diversification

Despite the natural pull investors may feel toward stocks similar to those they’ve had good experiences with, the best way to reduce risk in stock portfolios is to diversify. Diversification is a practice investors use to reduce risk in their stock portfolios, as well as maximizing returns by investing in various industries that will most likely react differently to the same event in the market.

To make wise investment decisions, investors must be aware of the two types of risk they face: undiversifiable risk, or market/systematic risk, like inflation, interest rates, exchange rates, political instability; and diversifiable risk, which is the unsystematic risk specific to a company, industry, market, or country. Undiversifiable risk is assumed by all investors and nothing can be done to mitigate it, but diversifiable risk can be managed with a diversified portfolio.

How to Diversify

To reach your long-term financial goals and avoid taking risks that threaten those goals, most experts agree that diversification is key. A properly diversified equity portfolio should contain stocks from different industries, valuations, growth rates, countries, and even company sizes to reduce volatility and exposure to loss of capital. The more unrelated the stocks in your portfolio, the less likely they will be subject to the same risk that is common in the same industry.

One example of this risk would be the effect an automotive worker strike would have on automotive stocks. If your portfolio is made up of mostly automotive stocks, this kind of event could lead to a considerable drop in its value. However, a diversified and balanced portfolio could weather these events because they’d only affect one or two of your stocks.

How Many Stocks Should You Own?

Like most things, there is no definitive number of stocks that applies to all situations, but most experts agree that 15 to 20 stocks across different industries is optimal. And while diversification is a crucial part of a good portfolio, overdiversification leads to its own complications.

Overdiversification occurs when the investor holds a large number of stocks, which makes it very difficult to know the individual companies well. When there are too many different companies to keep track of, the investor is at greater risk of making irrational decisions that could negatively impact the portfolio's return. If your portfolio contains 100 stocks, there may be less overall risk that one stock loss harms your return, but there will also be less benefit from a great investment. Striking an appropriate balance that keeps you knowledgeable about and engaged with your investments across a varied amount of industries is essential to reaching your long-term goals.

Diversifying your stock portfolio will help you manage the risk of the price movements of your assets, but it can’t completely eliminate risk and volatility.