The Insider Secret to Diversification
by Brian T
Mikes
Wall Street’s full of famous sayings. Some are funny. Some are serious.
But they all carry little bits of invaluable wisdom that can’t be
ignored. Some of my favorites are:
“Bulls and Bears get rich, but pigs get slaughtered.”
“Nobody ever lost money taking a profit.”
“A rising tide lifts all boats.”
So what do these sayings have to do with investing?
All of these lyrical gems, and hundreds of others, are grounded in
reality. What they lack in specifics, they make up in wisdom. Not being
too fearful to invest, not being too greedy, cutting your losses, and
letting your winners run.
You could spend an entire year analyzing each and every saying. But
you’ll quickly realize that some of them are more important than others.
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One that’s really important: “Don’t put all your eggs in one basket.”
It’s a simple thought but carries a lot of deeper wisdom. It speaks to
the importance of investment diversification. Unfortunately many
investors don’t follow this wisdom. Eventually every investor learns
the lesson . . . some the hard way. Remember all the investors who’s
life savings were invested in Enron? Their tragedy could have been
avoided by simply diversifying their investments.
But diversification isn’t simple. How do you know if you’re diversified?
Before I get to that, let me make one point. Diversification is a
double-edged sword. If you aren’t diversified enough you’re putting your
investment portfolio at risk. However, if you’re too diversified, a big
gain from an investment has little impact on your overall portfolio.
Some financial institutions have complex computer software programs which tell you if
you’re diversified or not. But, believe it or not, I have a very simple
way of looking at investing. If you’re going to invest in individual
companies the minimum I recommend is 20 stocks.
Why 20?
I wish I could say the number 20 was calculated by a super-computer or
developed by a math wizard. But it wasn’t. I actually calculated the
number using a little simple logic, and the back of an envelope.
Here’s how I figured it out.
Take your portfolio and divide it into 20 parts. You’ll find each
investment makes up 5% of your entire portfolio. Now diversification is
all about limiting risk. So, each investment in your portfolio
should have a stop-loss level or a point at which you will exit the position if
it falls.
I don’t have time to go into all the details of stop-losses here, that’s
for another article. All you need to know is in general most investors
use a stop loss level of 20%.
So a little math. With 20 investments and 5% of your portfolio into
each, and a 20% stop loss . . . your maximum risk on any stock is 1% of
your portfolio. If you lose 1% of your investment portfolio it’s a loss
you can recover from.
It’s a simple way to invest, yet it protects you from catastrophic loss.
And catastrophic loss has a tendency to knock would-be investors out of
the market – for good.
Again, this is only a rule of thumb. Determining what’s appropriate for
you might take a little more work. And, I’ll leave you with this one
thought. Like everything in life, there can be exceptions.
One famous investor even quipped, “I recommend putting all your eggs in
one basket, and watching that basket very closely.”
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