We have all heard that we want to make sure our portfolio is diversified, and I’ve definitely said that on this podcast many times before. But what does that mean exactly?
Well, that’s the topic of today’s episode. We will go through 7 questions that you can ask to make sure your investment portfolio has all the characteristics of a diversified portfolio.
1. Do you have any market cap deficiencies?
Large cap refers to companies worth 10 billion or more, mid cap refers to companies 2-10 billion, and small cap refers less than 2 billion. What I like to see is an amount in each of these three categories. Too often, when I review a client’s portfolio, it is only invested in something similar to the S&P 500, which makes up the largest 500 companies in the US. In other words, it’s all in large cap stocks. We’ve got to incorporate mid size and small cap companies to increase your diversification and potentially help your returns over the long run.
2. Are you only invested in companies that are headquartered in the U.S.?
Another issue that I see when I look at people’s portfolios is something called “home bias.” In other words, they have all of their money in their home country. That’s understandable, and give the last 100 years of economic progress and stock market progress we’ve seen, I think it’s perfectly fine to have some kind of home bias in your accounts. But I don’t want you to abandon international stocks entirely.
Because there will be a period of time in the future where international does better than the US, and we want to be ready for that. There is a cycle, no one knows when it starts, but there’s a cycle in which US will do better than international and vice versa.
For instance, in the 1980s, there was a 6 year stretch where international outperformed. Then in the 1990s US stocks outperformed international. Then in the 2000s, international outperformed US stocks, and in the 2010s until today US stocks have outperformed international ones.
When will it cycle again? I have no idea but you should have international stocks in your portfolio for when that day comes.
3. Are your stocks spread across multiple sectors, or are you concentrated in just one corner of the market?
This one is straightforward but very important. Does your portfolio include all sectors of the market? Including energy, communication, health care, consumer stocks, financial services, and more?
4. Do you have style diversification among your stock holdings?
Now this question refers to the terms growth and value. Growth stocks are companies that offer strong earnings growth while value stocks appear to be undervalued in the marketplace. You can own funds that contain growth stocks, or value stocks, or a blend of both. In my mind you want to have both of those in your portfolio and not be tilted too much one way or the other.
5. Do you have more than 10% in one single stock/investment?
A lot of the people I meet have avoided single stocks. That’s fantastic! Unless you have a ton of time and interest as well as the emotional fortitude to take on that huge risk, you should probably avoid single stocks altogether. There’s nothing wrong with us admitting that we are not the next warren Buffett.
Now if you do have single stocks, how much of your portfolio is in them versus a well diversified index funds? I hope
6. How much of your portfolio is in your 10 largest holdings?
When you consider all the funds and or single stocks you own, how much of your portfolio is in your top 10 largest holdings? Ideally you would say less than 10%, because if you had more than 10% of your portfolio in 10 stocks, I would say that doesn’t sound too diversified to me.
I have come across portfolios that I’ve looked at where people are invested in good funds, but when you look into those funds, you see that 30 to 40% of those funds are invested in 10 single stocks. And that simply puts you at a risk that those companies with the largest position will underperform in the years ahead and drag down your returns disproportionately.
7. How many different holdings do you have?
The last thing I want you to consider is how many different companies do you have ownership in? Ideally, this number is in the thousands, and not the hundreds.
The US market has around 4,000 companies that are publicly traded, and there are thousands of international stocks as well. So if you only have a hundred of even 500 stocks in your portfolio, you’re missing out on quite a lot of investment opportunities and diversification opportunities. So aim to get that number into the thousands to ensure you have the diversification you need.
Wrapping Up
Let me see if I can summarize here: You should own large, medium and small sized companies. Inside the US and outside of it. In all different sectors of the economy. In high growth companies and more stable “value” oriented companies. You really shouldn’t own single stocks, but if you do, make it less than 10% of your investments. Make sure you don’t have a very high allocation in your top 10 holdings. And aim to own thousands, not hundreds of different stocks.
Now I know that’s quite a lot, but if you follow those 7 steps your portfolio will thank you, and you will be better able to sleep well at night knowing that you’ve really reduced your risk of not being properly diversified. And that will give you much better odds of creating that income for your retirement that we all want.