Last week we discussed the importance of asset allocation, or finding the right mix between stocks, bonds and cash. But we’re still not quite ready to go on a buying spree until we consider the issue of diversification.
Grandma was right when she said not to put all your eggs in one basket. Spreading assets sufficiently over different specific investments allows you to mitigate the impact of unforeseen individual mishaps on the entire portfolio. Thankfully, proper diversification does not require holding hundreds of different investments. A portfolio can be reasonably well diversified with as few as 15 or 20 holdings if properly constructed by exploiting the concept of correlation.
Correlation is a statistical term used to describe the degree to which two different quantities behave together under external stimuli. Suppose for example that two stocks A and B move simultaneously up or down in lockstep. These two stocks would be said to be perfectly positively correlated. If they move together, adding some of stock B to your holdings of A would change nothing and would not reduce your overall risk level. One might imagine two firms such as Ford and GM, which demonstrate a relatively high correlation over time, or CVS and Walgreens. Not much diversification to be gained here.
Conversely, if two stocks C and D moved in equal and opposite directions, they would display negative correlation. In a perfect world, mixing stocks C and D could neutralize portfolio risk. In the real world, there are no perfect offsets, but it is relatively easy to select a basket of holdings that display low correlations over time to reduce overall risk. Using this construct, one can build a reasonably diversified portfolio with around 20 stocks. Mathematically, adding the 21st or the 101st stock to the mix contributes little additional diversification.
Of course one easy way to add diversification is to bypass the stock selection entirely and invest in mutual funds or ETFs. These vehicles allow you to leverage your cash investment across dozens or hundreds of individual issues in one bite. For example, investing in one of the S&P 500 index ETFs essentially allows you to own a small piece of 500 different stocks across all the sectors of the broad US large cap market. Voila, instant diversification.