What is diversification?

Ryland Goldman - Saturday, May 1st, 2021

At some point, all companies will end. They could go bankrupt, be acquired, or just become irrelevant enough not to matter. When choosing what stocks to buy, you need to be protected enough from sudden changes in a single stock through diversification.

Diversification is when you make sure that you are, well, diverse. To be more specific, you shouldn't have too much money in a single stock, sector, size, asset class, or country. A good way to stay diversified is to use funds, which we will cover in the next article.

Single stock
Take this hypothetical example: Amazon Prime raises their pricing and half of the subscribers leave. Amazon stock drops 15%. If your whole portfolio is in Amazon, then it would drop 15%. To stay diversified, you should invest in many different stocks. If your portfolio was 33-33-33 in Amazon, Costco, and Walmart, then your portfolio would only drop 5% as a whole. A good rule of thumb is to have a maximum of 10% to 15% in any single stock.

Let's keep our stocks from the previous paragraph, but change the scenario. If Black Friday is a total faliure and all retailers go down 10%, your portfolio isn't protected enough. By keeping other sectors, you can be safer for declines like this. A good portfolio should have all the sectors. Fidelity provides a chart showing weighting reccomendations from CFRA and Argus.

You shouldn't have too many small-cap stocks, but not enough could lower your returns. Smaller companies have more risk, so should be limited to about 20% to 30% of all your holdings. While they might not always be the best fit, they are generally a critical component of any moderate or aggressive portfolio.


Asset Class
Some people like all-equity portfolios, which just have stocks, but some people should consider other asset classes. Bonds are a great way to lower risk in a portfolio while generating income that you can use, and things like commodities or cryptocurrency can be used to hedge inflation. Also, you should consider keeping some cash in your portfolio in case you need it.

Just like having multiple sectors, sizes, and stocks, it is important to own companies outside of the United States. International stocks aren't as affected by things that could heavily change domestic ones, like interest rates, inflation, or politics. The amount of international companies you own should be just under what you have in small-caps, about 20%.

Remember, just because you are diversified doesn't mean that you won't lose money. It just decreases your overall risk by owning many different things. Also, try not to over-diversify. Having 15 individual stocks with 5 or so funds is much better than having 300 individual stocks. Stick with what you can keep track of.

Next: What are funds?