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Is diversification stopping you from making a million?

If you want to build a portfolio of single company stocks, diversification is vital. That said, being over-diversified could be a recipe for poor performance.

Feeling lucky?

Build up a portfolio of 40 or 50 stocks and you should have no trouble sleeping at night. Why worry about a fall in the price of oil or a sector-wide drop in supermarket sales when, say, Royal Dutch Shell and Tesco only constitute a small proportion of your portfolio? With the possible exception of a general market slump, any drop in the share prices of these stocks could be greeted with a shrug of the shoulders and the knowledge that your other holdings should be able to compensate.

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The trouble with running such a substantial portfolio however, is that the larger it gets, the more it will begin to track the index its constituents are a part of. Put simply, owning a large number of FTSE 100 companies will give you a similar return to that generated by the FTSE 100 index. You may as well purchase a tracker and put your feet up.  

Moreover, a large portfolio means that keeping in touch with your investments could prove exceptionally time-consuming. Fail to regularly review your holdings and you run the risk of overlooking problems as they emerge. 

There’s also the fact that the more stocks you add to your portfolio, the greater the cost of acquiring (and eventually selling) the shares. Even if you buy and sell only once, you’re still roughly £20-£25 down in commission costs, irrespective of how that specific company performs over the time that you own it. All this before stamp duty and the spread you pay when buying and selling the shares have been taken into account.

On the flip side, those with highly concentrated portfolios might own only a small number of companies – sometimes as few as four or five. Others might have slightly more stocks but a disproportional amount of their capital invested in their best ideas.  

The possible consequences of this approach aren’t hard to fathom. Pick the right stocks in the right industries at the right time and — thanks to the high level of concentration — you could well be on you way to early retirement. Of course, pick the wrong companies and you could be sitting on substantial paper losses if just one of your stock picks fails to perform, particularly if it’s a speculative, illiquid small-cap company.  

Happy medium?

Thanks to investors having different financial goals, investing horizons, required returns and tolerance to risk, it would be absurd to suggest that there should be a standard size of portfolio that all should be working towards. In my opinion however, anything more than 15-20 stocks and you run the risk of being too diversified. Anything less and the stock-specific risk may be too great to justify the possibility of substantial returns.

This view isn’t dissimilar to that postulated by legendary investor, Warren Buffet, who suggested that investors adopt a “punch card” system when selecting companies for their portfolios. In Buffet’s opinion, investors would make better decisions – and probably emerge with greater wealth – if they were restricted on the number of companies they could buy shares in over their investment careers. Follow this approach and you may just make a million over the long term.

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And if you click here, we’ll show you something that could be key to unlocking 5G’s full potential...

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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