One of the keys to investing is balancing risk and reward. And one way to help with this is to employ thoughtful portfolio diversification. Too much diversification can prevent market-beating returns. On the other hand, sticking to just one stock may put investors at too much risk. An approach somewhere in the middle, however, could offer investors a chance to outperform the market while simultaneously reducing volatility.
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But what is the right way to diversify the stocks in your portfolio? For the most part, the answer depends on investors' knowledge of investing, their willingness to expose themselves to volatility, and the time they want to spend looking for good investments. Ultimately, your approach should align with the type of investor you are.
For investors trying to decide what method works for them, here are three different approaches to portfolio diversification for three different types of investors.
1. Passive method: Buy market indexes or mutual funds
This approach may work for you if:
You have very little time to devote to understanding stocks and want to automate your investment strategy while minimizing risk.
If you're not able to hone your financial literacy, develop skills to analyze financial statements, or learn how to value stocks, this doesn't mean you can't build a portfolio of stocks. You'll just want to ensure you're well diversified. Fortunately, there's an easy way to do this, suggested by famed investor Warren Buffett himself.
Ninety-eight percent or more of people who invest should "extensively diversify and not trade," Buffett has said. Specifically, these investors should buy a very low-cost index fund, the Berkshire Hathaway (NYSE:BRK-B) (NYSE:BRK-A) chairman and CEO advises. Examples of index funds that track market indexes include the Vanguard 500 Index Fund Admiral Class (NASDAQMUTFUND: VFIAX) and the Vanguard S&P 500 ETF (NYSEMKT: VOO). Index funds are simply funds invested across large collections of companies in the same manner that popular indexes aggregate performance of a group of companies in order to track the broader market's performance. Popular indexes include the S&P 500, Dow Jones Industrial Average, and the Nasdaq 100. Investing in an index fund allows investors to buy a single ticker symbol that diversifies investments across all of the companies in a given index.
Investors who want to utilize the passive method of buying stocks should dollar-cost average into a single low-cost index fund or several different low-cost index funds. Dollar-cost averaging means investing the same amount each month -- no matter what the market does. This enables investors to avoid market timing and reduce the risk of sinking an outsize sum of money into stocks before a market downturn.
"If you like spending 6-8 hours per week working on investments, do it. If you don't, then dollar-cost average into index funds," Buffett explained in a 2005 question-and-answer session. "This accomplishes diversification across assets and time, two very important things."
2. Balanced method: Find a middle ground
This approach may work for you if:
You have a basic understanding of stocks and are willing to do limited research to identify good companies to invest in.
Another approach to portfolio diversification investors can adhere to is to find a middle ground between making big bets on just a handful of stocks and index fund investing. After all, for anyone with even a slight inclination to learn about stocks and to pick their own, it may be worth doing.
Indeed, even though Buffett strongly encourages the bulk of investors to pursue extreme diversification by investing in index funds, he is just as adamant about more knowledgeable investors avoiding this sort of diversification: "Diversification is protection against ignorance. It makes little sense if you know what you are doing."
The reason Buffett encourages more knowledgeable investors to consider picking stocks instead of buying index funds is because these investors can put effort into building a portfolio of excellent businesses, giving them a good chance of earning higher returns than if they were buying index funds.
So, what could a balanced approach to portfolio diversification look like? If you want to pick your own stocks while still benefiting from diversification, research shows that portfolio volatility is greatly reduced with as few as 20 similarly weighted stocks.
Note: I say "similarly weighted" here because a portfolio with 20 stocks that has much of the money skewed toward just one or two stocks would mean the portfolio's returns are far more reliant on the bigger positions than the smaller ones. Investing similar amounts of money into each stock in a portfolio, however, spreads risk across each of the companies in a portfolio.
Burton Malkiel, author of A Random Walk Down Wall Street, explains:
By the time the portfolio contains close to 20 [similarly weighted] and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.
With this said, if investors who are picking their own stocks find that their portfolios are similarly weighted across as many as 40 or to 50 stocks, they may want to reconsider whether their research is thorough enough and if their standards for what constitutes a valuable investment are high enough. Even Buffett and his partner, Charlie Munger, have resorted to settling with just "one good idea a year."
3. Active method: Invest in a handful of excellent businesses
This approach may work for you if:
-- You have a deep understanding of stocks, financial statements, and methods for valuing stocks.
-- You have time to regularly read companies' quarterly and annual financial statements and listen to earnings calls.
-- You are willing to spend five to 10 hours a week analyzing companies.
For the most educated and committed investors, willing to comb through financial statements and exercise patience until he or she finds excellent, long-term investment opportunities, there is a third approach that may be even more fitting: Invest in quality companies according to your own confidence levels, analysis, and conviction -- even when this means only owning just five to 10 companies.
One of the best ways I've seen this mindset articulated was by value investor and author of F Wall Street, Joe Ponzio. He uses a simple formula: Diversification = 1 / Confidence. "How diversified you choose to make your portfolio is entirely dependent on how confident you are in your company," Ponzio explains in F Wall Street.
On a similar note, Buffett tells these more active investors that want to put in hours of their time every week into analyzing stocks -- investors Buffett refers to as those who want to "bring intensity to the game and start evaluating businesses," -- that diversification is "a terrible mistake." To these investors, Buffett advises: "If you can identify six wonderful businesses, that is all of the diversification you need. ... Very few people have gotten rich on their seventh-based idea."
Therefore, for active investors willing to take the time to understand their investments inside and out, they should invest in more concentrated positions, according to their confidence. These investors could get away with owning as few as a handful of stocks.
Does diversification actually reduce risk?
While on the topic of diversification, investors should understand that increased diversification and reduced risk don't always correlate. Sure, if you define risk as the deviation from the mean (in this case, the mean would be market indexes), then this might be true. But is this really a fair way to define risk? Though the volatility for a portfolio of a handful of quality companies may be greater than an index fund since company-specific news can have a greater impact on a more concentrated portfolio's overall value in the near-term, this doesn't automatically imply the smaller portfolio's risk-to-reward profile is worse than an index fund. Instead, this just means that the portfolio is more volatile.
For instance, a concentrated portfolio invested in just a handful of excellent businesses will likely see more volatility on a day-to-day, month-to-month, and even year-to-year basis. But if the investor who picked the stocks for the more concentrated portfolio purchased stocks he or she believed were trading at a discount to their fair value and also possessed competitive advantages such as high customer switching costs, low-cost advantages, network effects, or powerful brands, the portfolio will likely appreciate more than an index fund over the long haul. This is because the index fund is invested across a large group of companies without any regard for valuation or quality -- an investment method that almost guarantees lower returns than a portfolio constructed by an investor who understands each security in the portfolio and purchased those stocks at prices he or she believed were good prices.
With this in mind, a more concentrated portfolio made up of wonderful companies may seem riskier in the near-term, but if it has a better chance of outperforming the index fund over the long haul, it is ultimately a lower-risk portfolio. Diversification and risk, therefore, do not always correlate.
In Berkshire's 1993 shareholder letter, Buffett eloquently explained this concept.
The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as 'the possibility of loss or injury.'
Buffett concluded his argument by saying:
[I]f you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.
So before you automatically choose extreme diversification, don't let the flawed argument that volatility and risk are the same things fool you. They're not. Of course, if you're uncomfortable with volatility, it's fair -- and probably wise -- to give weight to how diversification can mitigate it. But reduced volatility doesn't always translate to lower risk.
How many stocks should you own?
Deciding how many stocks to own is ultimately a very personal decision. Hopefully, these three approaches to portfolio diversification can help guide you in finding what works best for you.
Of course, investors don't have to choose one of these three strategies when deciding how to diversify their portfolios. These are just guidelines and frameworks to help you in your thinking. An investor who understands financial statements and has some time to invest in stocks, for example, may choose to invest a portion of their portfolio in an index fund and buy 15 to 20 stocks with the remaining portion of the money they have invested in stocks. Others may opt to follow Buffett's advice for active investors, identifying about six excellent businesses.
Simply put, there's no one-size-fits-all approach to portfolio diversification. The right strategy for one investor could be disastrous for another. Take inventory of your skills, time, and willingness to tolerate volatility and proceed accordingly.
This article originally appeared on The Motley Fool.