Diversification is another concept that need to be really understood by all investor. By using diversification you are certainly reducing exposure to the risk of individual item. And this is a good thing to do. But on the other side of the coin, if you are using too much diversification, not only you induce additional transaction cost, but also you are limiting your profit that you could earn. Let’s found out exactly why and how it works

What is Diversification

Simply put, diversification is spreading your money to more than 1 type of investment. In term of stock / share trading, diversification could be investing in more than 1 stock, investing more than 1 type of industry, investing big, medium and small size company, etc.

Diversification Reduces Risk

Let see how and why diversification can reduce the risk. For example you have $10,000 to invest in stock market. And you want to invest in stock of company XYZ. What is the risk ? The risk is when the price of XYZ stock goes down. Now, let us simulate what happen if the stock go down by 50%:

1. Without diversification: you only buy XYZ stock, so all $10,000 is invested in this stock. If the stock goes down to 50% then the value of your stock is now $5000. (You have lost $5,000)
2. Diversification with 2 stocks: Let see if you do some diversification and instead of only investing in 1 stock, you invest in 2 different stocks: $5000 XYZ stock and $5000 other stock. So, let say the price of the other stock did not change, then if XYZ is 50% down, then your XYZ stock now worth only $2500, total value of your portfolio is $7500. (You have lost $2,500)Now, compare to (1), by using diversification, you have already reduce your risk by 50%. Now you only lost $2500 instead of $5000.
3. Diversification with 4 stocks:Let see further what happen if you do diversification with 4 stocks: $2500 XYZ stock, $2500 stock A, $2500 stock B, and $2500 stock C. With XYZ down 50% and other stays the same, you now incur a lost of only $1250.
4. Diversification with 100 stocks: If you do further diversification and invest in 100 stocks ($100 each), by the similar calculation, you will get that you only lost $50 for exactly the same events.

Clearly, by using diversification, we can see that risk have been distributed and the exposure of each item is reduced.

Diversification Limits Profit

Now, let see the flip scenario: what if the XYZ stock increase by 100% , yes, it doubles. Also we want to see the transaction cost – if each transaction cost us $10, what’s the correlation with diversification.

1. Without diversification:You only buy XYZ stock, hence the transaction cost is $10. The stocks has doubled in value, then your portfolio is now worth $20,000. A nice profit of $10,000. After transaction cost: $9,990 profit.
2. Diversification with 2 stocks: You buy 2 stocks, then your transaction cost is $20. The XYZ is now valued at $10,000 (asumming the other stock stays the same), then the portfolio is valued at $15,000. A profit of $5000. After transaction cost: $4,980 profit.
3. Diversification with 4 stocks: With 4 stocks, the transaction cost is $40. Total portfolio is $12,500 or a profit of $2,500. After transaction cost: $2,460 profit.
4. Diversification with 100 stocks: With 100 stocks, the transaction cost is now $1000. The total portfolio is now $9900+$200= $10,100. After transaction cost: $900 lost.

So, from this example we can see the transaction cost is going up in parallel with the number of diversification that we did. And the profit ? The more diversification we did, the less profit we got.

What To Do

The general wisdom is that we need to balance between minimizing risk and maximizing profit. It’s not really a good experience having your stock pick hit a jackpot and the stock doubles in value, but because of too much diversification you even cannot profit from it (see condition no (4) above).

So how many is enough ? It’s all depend on the size of your capital. The general rule that might be suitable for you is that you should not lost more than 5% of your total portfolio for any single transaction.  So, in this case, with $10,000 capital you should not lost more than $500 for any transaction. So if you want to tolerate 50% drop in value, that will be the $500. So, the value for each portfolio will be $1000. Or you will do diversification with 10 stocks.

You may want to vary your level of risk as well. For example 50% drop for blue chip companies maybe already very significant, but for small caps companies probably it’s still within the expected volatility. So, you need to work out your overal plan according to the type of the portfolio and your exit strategy.

If you have higher capital, you probably could make more diversification because:
(1) the proportion of transaction cost will be smaller
(2) you will be able to buy higher quantity of stock that will multiply the profit (and also loss) of the investment

Conclusion

You need to do diversification to reduce your exposure to certain risk associated with each item of your portfolio. But you need to do it so that you minimize your transaction cost and make sure any significant profit will give significant boost to the overall portfolio.

Happy Diversifying !

Denis Kristanda