Portfolio diversification is a foundational principle of investing, a way to ensure that a disastrous stock pick will never wipe out too much capital.

Exchange traded funds (ETFs) have grown into a popular and effective tool to ensure too many eggs aren’t in one basket – and an easy way to invest in an industry; pharmaceuticals, say – without trying to pick a winner.

Beyond ETFs, the possibilities for diversifying a portfolio are many. 

For example, choosing stocks of different-size companies from various industries and from different parts of the world. Thus, the impact of a market turndown for a sector or geographical sector likely would be blunted. You don’t even need a foreign broker: many solid growth companies based overseas are traded on U.S. exchanges as American Depositary Receipt (ADRs) and as ordinary shares with dollar denominations.

But when does a broad portfolio of stocks strain the bounds of practicality by becoming too large, varied or complex? 

Remember, an investor must have sufficient time, energy and interest in order to monitor and evaluate equities with the goal of identifying when they become candidates for sale (or deeper ownership). Conversations with longtime leaders of BetterInvesting suggest that a diverse basket of 10 to 20 companies is ideal for the average investor. Clubs with large memberships might consider a few more.

Academic studies confirm the opinion. In “Modern Portfolio Theory and Investment Analysis,” Edwin J. Elton and Martin J. Gruber assert that the benefits of diversification significantly decline when the basket exceeds 20 stocks.

Recently, Dan Boyle of BetterInvesting’s Securities Review Committee offered sound advice for a BetterInvesting-style stock picker with an eye on diversification: Just keep buying high-quality growth stocks. Firms with a good chance for double-digit growth in sales and earnings, strong cash flow and a reasonable valuation tend to hold value better than peers in market downturns.

Sector weightings within portfolios are worth considering, though some sectors may be omitted. Low-growth areas of the economy – utilities, for example – may simply not provide sufficient return opportunities.
 

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This article was originally published in the November 2019 issue of BetterInvesting Magazine.

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