While it is possible for any investor to pick out and invest in a company that more than doubles in price, the chances are that, most of the time, mistakes will be made. In fact, the chances of you picking such a company when you only have one attempt are pretty slim. A downturn in the sector, stalling earnings growth, or even a profit warnings can all contribute to disappointing share price performance and, when you only have one stock in your portfolio, the effect on your financial future can be significant.
Diversification
It makes sense, then, to buy a number of different stocks. Not only does this give you a better chance of finding the best performing stocks, it also allows you to tap into different parts of the economy which may prove to be more appealing spaces than others. For example, investing solely in the oil sector over the last year would have seen your net worth take a major hit, while the same could be said about the banking sector during the credit crunch and the technology sector at the end of the last century.
Diversification, then, reduces the risk of your portfolio. Clearly, it cannot reduce the risk of investing in general, since even if you bought every single stock in the FTSE 350, you would still be exposed to market risk, where a downturn in the global or UK economy could cause the index level (and, therefore, its constituents’ valuations) to fall.
However, diversification can reduce the amount of company specific risk that you face. In other words, the risks to a company could take the form of a fall in revenue, one-off items that increase costs, or a failure of management to adopt the correct strategy. By investing in a number of different companies, you reduce the impact of such challenges on your portfolio and, in the long run, this is likely to lead to a lower level of volatility and overall risk for your investments.
How Much Is Enough?
Clearly, the level of diversification that is sufficient for a private investor is highly subjective. It needs to be great enough to reduce company and sector specific risk, but not so much that you are simply tracking the index (or else an index tracker would be more logical). As a suggestion, a portfolio that contains between 20 and 40 stocks could be reasonably well diversified, so long as they were from different sectors and had differing share price drivers.
The good news for investors is that, with the advent of the internet, it is easier than ever to diversify your portfolio at a relatively low cost. For example, aggregated orders may offer less flexibility than standard online share dealing (normally trades are only executed once per week) but the cost can be as little as £2 per trade, which means that you can buy shares in many more companies without paying over the odds in charges.
