Reduce Investment Risk with Stock Diversification

A common concern among those who buy stocks, especially in our volatile times, is how to reduce the risk that comes with owning stocks. How does one reduce the risk that one of your picks could sour and significantly reduce the overall value of your stock portfolio? This concern has been increased by investment disasters like Enron (which became a stock worth nothing) and the current bundled credit crisis. With the fears of bad times ahead, investors need to be aware of the basic strategies that ensure that a single bad pick will not completely destroy the value of their’s investment portfolio.

Investors have been concerned with this problem for decades. In 1949, Benjamin Graham (mentor of Warren Buffett) wrote in “The Intelligent Investor” that one of the best solutions was to diversify one’s stock portfolio.

The way that diversification works is that it spreads the risk among many stocks instead of having it concentrated into just one investment. Investing in just one stock is, as the old saying goes, putting all your eggs into one basket. By investing in more than one stock, you lessen the possibility that a single bad pick will wipe out your entire portfolio.

Diversification comes with its own investment concern. By spreading out your investment money among several stocks, you lessen the risk that a single stock’s failure will ruin you; but you also decrease the benefit that a stock price increase will give you if you picked correctly. The logic says that if two stocks are better than one, then three, four or a hundred stocks are even better. Yet by spreading your investment over several stocks, you own less of any particular stock, so runs of good luck benefit you less. It is possible that you can spread your investments too thin.

So the question becomes “How many different stocks are necessary to adequately reduce risk, and at what point does the benefit of reduced risk level off?”

The answer that Benjamin Graham came up with in 1949 was that fifteen stocks was sufficient; later in 1968, he revised his answer to just ten stocks. The reason for the limit is that a portfolio of fifty stocks, according to Graham, is not significantly safer than a portfolio that contains only twenty stocks. By the time that you have diversified your portfolio with twenty-five stocks, you have reduced your risk by eighty percent, and the addition of another stock will not shift the risk much lower. Owning a hundred stocks will cut your risk by ninety percent, and it would take four hundred stocks to cut your risk by ninety-five percent. Unless one is totally adverse to risk (in which case, you should not be investing in the stock market in the first place), twenty-five stocks will dilate the amount to an acceptable level.

Reference: Ric Edelman. “The Lies About Money.” New York: Free Press (2007).