A diversified portfolio consists of a varied selection of stocks. Such portfolios substantially reduce the risk of a single, company-specific event wiping out a huge portion of your savings. Numerous factors, such as the types of companies whose stocks you invest in, will determine how many shares you must hold to be well diversified.
Systematic vs. Unsystematic Risk
A stock investor is exposed to two types of risk: systematic and unsystematic. The systematic risk results from factors that impact all corporations in an economy. A general rise in unemployment and the resulting decline in purchasing power, or a national calamity such as a terrorist attack, will influence all corporations. Therefore, you cannot avoid systematic risk if you are invested in the stock market. Unsystematic risk refers to events that impact a single company or a group of firms in an industry. Bad management, pressures from competitors, and declining demand for a type of product are all examples of unsystematic risk. By holding a large number of unrelated stocks, you can minimize the risk on your fortunes of an adverse event influencing a single company. Holding a large number of unrelated stocks in your portfolio is referred to as diversification.
Related vs. Unrelated Companies
No matter how many stocks you buy to diversify your portfolio, you cannot reap the full benefits of diversification if the stocks are in the same or related industries. If, for example, you buy 30 stocks, all of whose issuers operate in the hotel industry, even the best of your stocks will be dragged down by a decline in business travel that results from increasing use of teleconferencing. Even the stocks of trucking and airline companies move up and down together to some extent, as oil prices fluctuate. Therefore, the less related the industries of the companies in a portfolio, the fewer the number of stocks must be in it to accomplish the primary purpose of diversification.
Number of Stocks
Most experts agree that 15 to 20 stocks will provide sufficient diversification for an individual investor. Frank Reilly and Keith Brown, in their book Analysis and Portfolio Management, recommend 12 to 18 stocks for diversification, but there are dissenting voices in the investment community on this issue. Meir Statman, in a study published in the Journal of Financial and Quantitative Analysis, argues for at least 30 stocks. Following this many stocks represents quite a challenge for most investors. Ultimately, it is up to each investor to decide on a manageable number, but there are other alternatives to reducing unsystematic risk.
If the prospect of selecting and following more than a dozen stocks seems daunting, you may consider exchange traded index funds, commonly called index ETFs. The price of an index ETF moves up and down by the same percentage as that of the index it is based on. If, for example, the S&P; 500 index moves up 1.24 percent on a day, an ETF based on it will appreciate by the same percentage. Since the S&P; 500 contains 500 stocks, it is extremely well diversified. You can purchase an index ETF just like any stock. ETFs are traded on the stock market and are as easy to buy as any share.
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