Table of Contents
(Last Updated On: October 29, 2022)
Diversification refers to creating a mix of investments distribution to minimize the risk of losing its values when it is at risk and to prevent putting it all in one classification of investment only.
What is Diversification?
It came from the famous notion or saying that to protect your investments “do not put all your eggs in one basket, if the basket falls, all the eggs will break”.
The risk would be too high if you only put your investment in one asset class because if something happens you will have a hard time recouping any losses incurred. Investing has risk so the only way to minimize it is distributing the risk.
Good diversification means selection also of assets or investments that would react differently form changing movement of the economy.
If your focus is investing on stocks only, you can diversify your holdings by investing in the stocks located within the 7 indices of the market. You can select stocks for each of the Finance, Industrial, Holdings, Property, Services and Mining sector of the market.
Under each of these indices contains several stocks as well (yellow shaded)
For the example below, these are the major stocks under the holding index. To have diversification select only a few and don’t buy all the stocks under the Holding index. You can do the same strategy if you like property or the finance sector.
There are cases of different category of stocks even though they have different sector, for example, Ayala Stocks (ALI, ALLHC, ACEN) can all be hit together if there is a bad news related to its owners, although they came from different index sector. You need to look into these details as well and try to diversify by investing only in one or several of these stocks.
What are the examples of Investment assets?
There are different forms of investing vehicles that we can put our money to be able to grow it over time. Below are example of assets we can invest into and diversification on this class of assets means allocating a certain percentage on each type.
Stocks – These represents shares or portion of a publicly traded company. Companies issue them in exchange to raise money, and the shares are then traded (buy or sell) based on its potential. For us in the Philippines, we are most familiar with these class of asset together with Mutual funds.
Bonds – are units of corporate debt issued by companies and securitized as tradeable assets
Mutual Funds and ETFs– Both types of funds consist of a mix of many different assets and represent a popular way for investors to diversify. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day
Options – financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date
Annuities – a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future
Real State – private property in the form of buildings and land. Real estate can be used for residential, commercial, or industrial purposes, and includes any resources on the land such as water or minerals.
Is Diversification good for investing?
Diversification does not guarantee consistent winning when investing in the stock market, but since it distributes our investments on different types of assets it will improve our risk management, we will improve potential returns and achieve stable results over time.
When is Diversification not good?
The market conditions can vary from time to time. When investments are put in assets that have good fundamentals, overtime that asset will grow in value hence improving our income form investments. But when the market condition is not good, it will be hard to manage if there are too many stocks on a portfolio.
- There are however times that no matter how you diversify your portfolio of investments you will still lose your money. This includes severe conditions like war, bear markets, high inflation.
- Too much diversification will also give below average returns. For example if you have 100k for your initial investment and you decided to buy 50 different stocks you will only have 2k investment for each of the stocks. If it happens that 1 or 2 stocks gained at least 50%, you will only earn 1k for each of the stocks that hit the correct movement of the stock.
- You will lose focus on the portfolio management. I came to realize this one time when I had 10 stocks with a 100k portfolio, when the market condition is not good, all of the 10 stocks will fall down, later on, I could not select properly which stock will be my priority for cutting loses. In the end, I ended up holding all of the 10 stocks with big losses.
The photo below is an example of over-diversification as majority of the listed stocks are bought. When the market turns bearish, the owner will have a hard time managing the portfolio.
How many Stocks Should I hold to properly diversify my Investment but maximize returns?
Most investing books I found suggests 10-20 stocks for a regular investor.
For my case since I have been mostly trading stocks, I have a rough estimation on the number of stocks I would hold which depends on capital.
Again, these estimates are based from my experience and it may vary for each individual with different risk appetite. My consideration also includes ease of management and execution in times of negative market sentiment.
For less than 100K capital I maintain 2-3 stocks only. You can do a reverse calculation on the risk that you want to exposed. At this rate I have a risk appetite of 10-15% for each stock.
For 1M-3M capital, I maintain 6-10 stocks. Each with the same risk as above.
For 5M-10M capital, I maintain 10-15 stocks while for >10M capital I maintain 15-25 stocks.
Again, you should practice your risk appetite whether you are able to maintain it at these numbers. It takes time to develop and with the right practice, you can control your emotions during the time you need to make decisions on your investments.
Overall with proper diversification on investment, we can get protected from the market volatility overtime.