What’s the right amount of portfolio diversification?
After receiving $180m from the sale of PayPal, Elon Musk famously took those earnings and plowed it straight into launching Tesla and SpaceX. It worked out for Musk but for many others, concentration can blow up a portfolio.
Today’s younger investors are built differently, motivated differently — and are often taking greater risks:
- Bigger risk appetite: Younger investors are taking bigger risks through speculative bets and more concentrated portfolio holdings.
- Stock-based compensation: Tech companies/startups commonly issue compensation in stock — which can grow to make up a large portion of a portfolio.
What’s the right amount of diversification? When it comes to portfolio construction, ask yourself:
- How concentrated are you? If you do have a large amount of stock given by a certain employer, a more diversified portfolio in other areas of your account may be better.
- Can you stomach the losses? With a smaller number of holdings, your portfolio is at greater risk of bigger swings.
The greater the diversification, the closer your return will be to the market average. But to beat the market, investors often opt for a smaller number of holdings. A large portfolio also makes it more difficult to manage existing investments.
Give me a number: According to a study, 12-18 stocks achieve 90% of the benefits of diversification — assuming an equal weight and broad industry diversification.
If you’re concentrated in too little, investing in broad ETFs is a simple way to achieve broad diversification. Here’s a sample allocation for investors.