How to Diversify Your Portfolio?

What is Diversification? Is the (Almost) Daily Dividends pie on Trading212 Diverse? on youtube.com/@theDividendExperiment

We’re going to do a bit of a deep dive into the Trading 212 Pie, whether it’s diverse, and the concept of diversity in general. What is diversification? So, what is portfolio diversity or diversification?

Now, what a lot of people get wrong about diversity is they think that just having a load of stocks means that it becomes more diverse. But the basic premise of diversification goes as follows: 

If you have one stock, that means you’re 100% invested in one company. Basically, you ride or die with that one company’s fortunes. If that company goes up by 20%, then good news – your portfolio goes up by 20%, and that’s nice. 

But it’s only nice if it goes up. If that company gets into some trouble and falls 50%, then unfortunately, that means your portfolio does too.

Now, if you decide you want to spread your bets a little and buy two companies, 50% each, and if that company gets into trouble and falls 50%, that’s a much lower 25% down that your portfolio will be. 

Now, as you can probably figure out if you add another stock into the mix, the overall impact will be lower and lower and carry on like that. And this is the essential principle of diversification. In other words, don’t keep all your eggs in one basket.

It’s an idiom that’s been passed on through the generations for a good reason.

Now, this all makes sense, but we come into a few problems when you extrapolate it too far. Let’s say you have a hundred stocks in your portfolio. The overall impact of adding the extra stock at that point is so marginal it’s almost ineffective. 

And then, when you reach ETF portfolios in the thousands, the additional extra is probably unnoticeable at that point.

How many stocks are enough?

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So, how many stocks are enough to have a diverse portfolio? Even though many sources have an opinion on the appropriate quantity of companies to purchase in a portfolio, there is a lot of discussion on this exact topic of how many stocks you need in your portfolio. 

The widely used guidance is that 10 stocks are enough to have some benefits of diversification, all the way up to 30. After that, your portfolio essentially has market-level risk, so the benefit of the additional stocks doesn’t warrant you adding them to the portfolio. 

In fact, it could actually make it worse, as you’re either spending extra time to research the additional stock or adding it without research, both of which will impact you negatively – either through your wasting of time or portfolio returns.

Diversification Risks

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The other issue with diversifying your portfolio by simply adding stocks is that the stocks you’ve added may just be affected by similar factors.

In our earlier example, we saw that if we had two stocks, Stock A and Stock B, and both split 50% across the portfolio and we also saw that if Stock A fell 50%, it only hurt our portfolio by 25% on aggregate across the whole thing. 

However, the chances are that if something is affecting Stock A, it may well have an impact on Stock B too. When you diversify, you want to avoid the risks that affect your whole portfolio, or you might as well not diversify at all.

For example, let’s say you have Pepsi and Coca-Cola stocks in your two-stock portfolio. The government decided to put an 80% tax on sugary drinks, and now your whole portfolio is going to tank. And you might have two stocks, but they’re both going to get hurt by the same event. 

Therefore, in my opinion, you should aim for three types of diversification: sector diversification, geographic diversification, and asset diversification.

But what are these types of diversification? Let’s take a look at an overview of each of these types of portfolio diversification.

Portfolio by Sector Diversification:

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First, is sector diversification. If we go back to our Pepsi and Coca-Cola stock portfolios, these are not only in the same sector but for the most part, in the same industry too. Not very diverse at all. There are 11 stock market sectors that stocks can be classified as:

  1. Healthcare sector
  2. Materials
  3. Real estate
  4. Consumer staples
  5. Consumer discretionary
  6. Utilities
  7. Energy
  8. Industrials
  9. Communications
  10. Financials
  11. Technology

Both Pepsi and Coca-Cola are classified as consumer defensive, so ideally, we should add some companies from other sectors too. For example, that sugary drink tax we used to demonstrate earlier would have no impact on a mining company. 

So, the portfolio would become more robust by adding from different sectors.

Geographic Diversification:

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Secondly, geographic diversification. This is usually a bigger problem for people who have smaller local markets. While the US has the S&P 500, the UK has the FTSE 100, and the Portuguese stock market has the PSI 20 – much fewer stocks in there, and the capitalization of the market is way, way smaller. 

If all your portfolio stocks operate in one particular country, then something that impacts that country – maybe a war, a government change, or something geographic or even a natural disaster – will impact your portfolio heavily. 

But one mistake that people make here is they think they just need to buy lots of stocks from all around the world, and then it has geographic diversification. It’s actually more important where the company does its business and gets its money from. 

For example, the UK-listed Unilever gets 60% to 70% of its revenue from emerging economies.

Asset Diversification:

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Finally, asset diversification. Sometimes there are unavoidable risks that can impact the whole stock market. For this reason, investors may wish to hold other assets outside stocks too.

So, think along the lines of bonds, real estate, commodities such as gold or silver, and then more recently, things like cryptocurrency. 

Overall, different areas and sectors will have different strengths and weaknesses. For instance, more than 50% of the world stock markets are located in the US, and approximately 75% of the whole US market is represented by the S&P 500, which monitors the 500 largest US corporations. 

And then, a large proportion of the S&P 500 is made up of US tech companies too – or has been previously. Being home to big household names like Apple, Amazon, Google, Netflix, and Meta or Facebook earlier this year – these alone made up nearly 16% of the S&P 500.

The UK has a very different selection of top companies than those from the US. More emphasis is placed on financial services and oil and gas enterprises. So, you must examine what you’re holding more closely to ensure you’re not overexposed to the same things.

Even though certain places may appear more fascinating than others. For example, you may realize if you own a worldwide fund, a fund that monitors the US stock market, and a fund that covers tech businesses – there’s probably going to be a lot of overlap in there. 

And so, finally, is the almost daily dividends pie diverse? A cool feature of the tracking software Share Site that I’m using to maintain this pie is its diversity report. This diversity report shows portfolio diversity across different investment sectors, investment types, countries, and markets. 

So, let’s take a look at the sector breakdown. The five biggest sectors that they’re using to classify here are finance at 26.56%, consumer non-durables at 10.09%, miscellaneous at 9.19%, producer manufacturing at 8.26%, and process industries at 7.89%. 

If we go by their grouping of industry, we can see a pretty even split. The five biggest here are investment trusts/mutual funds at 9.18%, investment managers at 7.63%, major banks at 7.36%, real estate investment trusts at 7.3%, and household and personal care at 5.95%. And as it goes around, they’re spread pretty thin.

Let’s check out the country listings now. Remember, this is the country of listing, not where they obtain their revenue from. So overall, it’s not super relevant, but still interesting to look at.

Very heavy US weighting here, and that’s down to the fact that the US pays quarterly dividends and is more favorable for the pie. 

For this reason, if you’re wondering why Ireland is so high, this is because Vanguard funds register in Ireland, and I think that’s to avoid taxes. But please don’t assume if that’s not the main reason. And then there’s a little bit in the UK too.

Next, let’s look at the types of investment classes. Mostly ordinary shares as expected. The exchange-traded funds or ETFs will have the bond funds in there too.

So overall, not really a surprise here. What do you think? Is it diversified or not? I would say it’s pretty diversified when it comes to sector or industry but not so much when it comes to assets. 

But that’s not really a big deal in my opinion for this kind of portfolio. Geographic diversification is a little harder to quantify without deeper research, but overall, I’d imagine it’s fine. There are a lot of companies in the pie, and multinational conglomerates operating in many different countries.

Final Thoughts:

So, some final thoughts on diversification. While diversity is crucial for investors, we shouldn’t always adopt a “more is better” mentality, as there is such a thing as having too much of a good thing. 

While diversification, on the one hand, lowers the risk associated with having too few investments, on the other hand, owning too many assets might make it difficult to monitor their performance and increase the likelihood that you’re holding a lot of the same item if your funds have similar objectives.

The second and third funds you add to your portfolio will provide considerably more marginal benefits for diversity than the 20th, and that’s just the nature of how it all works according to the law of diminishing returns.

So, in order for it to be diverse, you should have a range of sectors, geographies, and assets in your portfolio.

The almost daily dividends portfolio holds up pretty well when measuring diversity, despite that not even being a factor taken into account when choosing the stocks to begin with. And what about your own portfolio?