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Stock Diversification My Way

April 13th, 2014 at 05:02 am

I follow a high-yield, high-risk investing strategy* under which I only invest in high yield dividend stocks**. The "high risk" part of the strategy speaks for itself. I am taking serious chances with my money. One way I reduce that risk is to spread my money among a certain number of stocks and industries. I make sure I put my investment eggs in many baskets. I decided long ago that the right number of baskets for me is 8 industries and 16 companies. Here is how I came up with those numbers.

If I invest the same amount of money in each company, then the more companies I include in my portfolio the more I evenly spread my risk among those companies. But as I increase the number of companies in my portfolio, I also increase the amount of time and work I must put into monitoring those companies and managing my portfolio.*** So I have had to find my personal comfort point balancing those 2 factors.

Stock guru Jim Cramer of the television program Mad Money tells his viewers that to be diversified they must own 5 stocks in 5 different industries. In his view, holding fewer stocks means you are not diversified enough. And holding more creates too much of a workload for the average part-time investor. Maybe so. But his approach places 20% of the risk on each of those 5 stocks (20% x 5 = 100%) and that is too risky for me.

On the other hand, a typical managed mutual fund may hold 50 or more stocks. That makes the risk per stock very low (if they were equally weighted, which they never are). But the work of monitoring and regularly updating my fundamental evaluation of that many companies is way too much for me.

So I have arrived at my middle ground of 8 industries and 16 stocks by simple math combined with some introspective intuition. I looked for the point at which further diversification did not (for me) deliver additional worthwhile risk reduction. I found that point at 16 stocks. With 16 stocks, the risk from each is 6.25% (16 x 6.25% = 100%). With 18 stocks, the per stock risk would only be reduced an additional 0.65% to 5.6% per stock. For me, that is not enough added risk reduction to justify the 12% increase in work that those extra 2 stocks would require (18 divided by 16 = 1.12).

But I cannot have those 16 stocks concentrated in too few industries. If I did, bad times for an industry could whack too big a slice of my portfolio. So, applying the same math-and-intuition approach I have arrived at an industry risk comfort level of 8, with a 12.5% risk share per industry (8 x 12.5% = 100%). Again, increasing the number of industries to 9 would only reduce the risk per industry to 11%, while increasing my monitoring workload by 12.5%. So I set a stop at 8 industries.

But (of course) there is going to be waffle room in that thinking because (1) special opportunities present themselves, (2) not every stock "deserves" a full 6.25% share in my portfolio, and (3) not every industry "deserves" a full 12.5% share in it either. That is why, as I write this, my actual portfolio holds 20 stocks in 10 industries. That makes my portfolio "accidentally" even more diversified. That is good. The extra work is not so good. But it is what it is and I will not complain (too much).

# # #

* My High Yield, High Risk Investing:
http://retired-to-win.savingadvice.com/2013/12/20/my-high-yi...

** Why I Only Buy Dividend Stocks:
http://retired-to-win.savingadvice.com/2014/01/01/why-i-only...

*** How I Stay On Top Of My Stocks:
http://retired-to-win.savingadvice.com/2014/04/09/how-i-stay...

2 Responses to “Stock Diversification My Way”

  1. rob62521 Says:

    I'm not the stock guru you are, but I think middle ground makes more sense than having too few or so many.

  2. Retired To Win Says:

    April 13th, 2014 at 01:02 pm
    rob62521 Says:
    I'm not the stock guru you are, but I think middle ground makes more sense than having too few or so many.


    Rob,

    In a way, it is all relative to how much time one is prepared to dedicate to staying on top of one's stocks. The more stocks in your portfolio, the more time it is going to take. But I still think there is a minimum number of holdings below which a portfolio's risk profile becomes too stress producing. And, as I indicated in my blog post, that number for me is 16.

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