Be diversified. Don’t put all your eggs in one basket. This is Rule 101, according to most investors.
What, however, is a suitable level of diversification? To answer this question, one must first ask why you would you want to be diversified in the first place?
In layman’s terms you must diversify to avoid the failure of anyone share having a large impact on your overall portfolio. This is also known as the removal of unsystematic risk presented by single stock volatility.
A portfolio that is not effectively positioned to remove unsystematic risk is vulnerable to a single share wiping out a large proportion of a portfolios value. A portfolio that is suitably positioned to remove unsystematic risk then only leaves an investor exposed to systematic risk, or market risk. This is the risk of equity market volatility and can’t be diversified away and is inherent to all portfolios.
When focusing on the removal of unsystematic risk one should refer to the Capital Asset Pricing Model (CAPM). The model was first introduced in the mid 1950’s by economist Harry Markowitz and later developed by Jack Treynor and William Sharpe who both went on to invent their namesake ratios commonly used in investment management today.
The CAPM formula can be used to judge the required return of an asset for the level of risk taken. All equity will assume a risk and the measure of risk in the Capital Asset Pricing Model is Beta.
Beta measures how risky a particular share is when compared to the underlying market. A Beta rating of 1 is the same as the market and a Beta rating of 2 means it moves twice as quickly as the market.
A Beta rating of less than 0 is a negative Beta, meaning the asset is negatively correlated to market, so if the overall market went up, you’d expect that asset to fall and visa versa.
As Beta is a key input to CAPM, this measure of volatility or risk should be at the forefront of building a balanced diversified portfolio. A mix of shares with different Beta ratings will reduce the correlation of the shares in the portfolio and provide protection against any sharp moves in the underlying benchmark.
Another key factor in diversifying is the number of shares in the portfolio.
Having few shares means sharp moves in one stock can cause significant divergence of the portfolio’s returns from the underlying benchmark where as having too many shares means the portfolio will simply track the underlying index.
According to Capital Asset Pricing Model having around 25-35 shares statistically means you have reduced unsystematic risk. Any more shares than this doesn’t reduce stock specific risk assuming equal amount allocated to each share.
So that, according to CAPM, is how many shares you need to diversify you portfolio.
However, those that follow Billionaire investor Warren Buffett will know he once famously said “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
