subject: Joseph Wang Financial Explains How To Diversify [print this page] Diversification is based on prudenceDiversification is based on prudence. Diversifying is to accept a lower return in exchange for a lower risk also.
If an investor was able to know what is the most value will go up in the future would not need to diversify, since in that case would invest all his money on that value and get the maximum return.
But in practice we do not know what that ideal value in advance so that the most prudent, even for very experienced investors, is to resort to diversify.
When diversification must take into account 3 main factors (the number, weight and type of values that comprise the portfolio) and 2 secondary (emrpresa subsector and geographical area).
Regarding the number of values that comprise the portfolio very thorough studies have been conducted in different bags that stand at about 20 the number of "ideal", taking into account the profitability and risk.
The greater diversification and lower risk would be achieved by investing in all securities listed on the Stock Exchange. For small and medium-sized portfolios that have the problem of having to bear too high a commission that would reduce profitability, as it would have to buy 200, 1,000, 5,000, ... companies, depending on the stock exchange concerned. But even very large portfolios would weaken their potential profitability, and that by buying all firms in a stock companies are buying low quality and poor behavior. The objective by investing in the stock market is to invest in the best businesses and avoid the worst. So you have to compromise between risk and profitability, and the studies cited above seem to conclude that from 20 values risk reduction is achieved does not outweigh the reduction in profitability.
20 companies is a large number for small portfolios in fees for the cost involved. As a guide could give these figures:
Portfolios up to 20,000 euros: About 5 values
Portfolios up to 100,000 euros: About 10 values
Portfolios exceeding 200,000 euros: about 20 values
These figures are merely guidance and not be taken as a fixed rule. It could be a purse of 400,000 euros (for example) with 8 values and have a good diversification. The most important factors to decide the number of values are:
Fees: One investor who has a broker with lower commissions may have a greater number of portfolio holdings with the same cost. The cost of the commissions is the factor that determines the theoretical maximum number that should be kept in a portfolio. An investor may be cheaper to have 10 values in a broker that 7 in another, for example.
The number of values that form the portfolio is not an end in itself. In other words, do not fix the number of values that we want our portfolio so inflexible and buy "whatever" to get to that number. For example, an investor should decide that your portfolio will be "about 10 of values", not "exactly 10 values." Be invested in companies that are considered a good investment, you should not buy a company without knowing just by having another company in the portfolio. It is preferable that such investor has 7 values he knows well to take those same 7 values and another 3 of those who have little knowledge only have 10 portfolio holdings. In the future you can gradually increase the number of values if it finds more companies to be convinced and fit your strategy . Nor should we put a strict limit above, if an investor knows and can accommodate 25 companies to invest in them should not give up 5 are not to exceed the "limit" of 20.
Regarding the weighting of the portfolio, of course not the same as having a portfolio of 10 companies in which each represents 10% of the investment to have a company equal to 50% alone and 50% is distributed among the remaining 9 companies. The more balanced are the percentages invested in each company the lower the risk of the entire portfolio.
Another point to consider is the type of companies in the portfolio. It has better diversification with a portfolio of 5 companies made up a bank, electricity, a telecommunications operator, a highway and a construction company with a portfolio of 10 companies comprised of 10 banks or 10 or 10 electrical construction, etc.. You do not have a portfolio representing all sectors listed on the Stock Exchange, but must procure the widest possible range keeping in mind not to "buy buy", but knowing what you buy. Same goes with the number of values is preferable to have 4 sectors in the portfolio which has a good knowledge to have those same 4 sectors and a more than superficial references are taken.
The 3 factors mentioned so far (number of companies, each company's weighting in the portfolio and sectors represented in the portfolio) are essential when designing a portfolio, you can not overlook any of them.
The 2 factors listed below (sub-sector and geographical area) are desirable and is best taken into account, but are not as important as the first 3.
Within the same sector can also be further refined taking into account the different types of companies in the sector. For example, if you have 2 companies in a particular sector in the portfolio gets more diversified if one develops all of its business practice in the local market and the other has a multinational character that if you buy 2 or local businesses 2 multinational sector. In utilities, for example, may have engaged in some phase of transportation and other to the stage of generation . Greater diversification would be achieved with a dedicated electric transport and another to the generation that dedicated transport with 2 or 2 dedicated to the generation.
Geographic diversification is also important, so we must take into account not only the place where the head office has every company, but the main areas of the world where it operates. At this point we must take into account the currency risk, which may act in favor or against.
Every portfolio should be diversified taking into account the factors mentioned in this article, but be flexible. Under any of the criteria presented here increases diversification and reduces the risk if the investor knows the business in which to invest. If you invest in companies, sectors, geographical areas, etc.. of which one has no knowledge chances are you are increasing the risk of the portfolio, although it seems a contradiction. Never buy without knowing what is bought only by increasing the range. When you invest in something that is not known to increase risk, not reducing it.
It is not necessary or prudent, buy all the values you want to have in the portfolio at a time even if you have a lot of liquidity. It is preferable to also diversify over time, spacing the purchases over several months or years depending on the particular situation of each investor and the market at that time.
by: Joseph Wang
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