Diversification is a way to reduce risk by adding variety to a portfolio. Assuming individual stocks are not perfectly correlated, the positive returns of some stocks should offset the negative returns of others. According to Investopedia, studies have shown that "maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction". Increasing the number of holdings beyond 25 to 30 stocks will reduce risk further, but at a diminishing rate.
Risk cannot be eliminated entirely through diversification. Some risk is systemic and affects nearly every stock. Example causes are inflation, interest rates, political unrest, and war. For this reason, it is a good idea not only to diversify within a portfolio, but also to diversify across different asset classes.
Consider the following graph, which plots the performance of the S&P 500 and the Dow Jones Industrial (DJI) Average over a 5-year period between June 1, 2009 and May 27, 2014. The S&P 500 increased by about 100%, while the DJI Average increased by about 90%. The trend is generally UP.
When I look at a graph like this, I wonder if the trend would continue or abruptly change course. Although the market can go up for longer than you could imagine it would, it could also turn on a dime.
Not long ago, we experienced a similar 5-year period of growth. The following graph plots the performance of the S&P 500 and the Dow Jones Industrial (DJI) Average over the 5-year period between October 7, 2002 and October 8, 2007.
Again, the trend is generally UP (although the average slope is not as steep as in the first graph).
Now, we know what happened in the period between these two graphs: the Global Financial Crisis of 2007-2008, considered by many as the worst financial crisis since the Great Depression of the 1930's. Large financial institutions collapsed, banks had to be bailed out by national governments and stock markets around the world tanked. Total losses due to the crisis are estimated to be in the trillions of U.S. dollars globally.
Looking at the graph above, it is clear that panic-selling during the crisis period turned out to be the wrong thing to do. Many investors lost a significant portion of their wealth in the process.
Of course, dividend growth investors have a different objective. We invest for the long term. We invest in companies that pay dividends and increase those dividends over time, even in times of crisis.
I started DivGro in 2013 and have grown the portfolio to nearly 6 figures in 17 months. Besides DivGro, I have other portfolios with different objectives. They have served me very well, but I've slowly scaled them down as my investments in DivGro increased.
This month, I sold most of the holdings in my other portfolios. I'm only keeping the best of the best.
The reason is diversification: I'm moving more of our net worth into real estate. We're buying a second house and turning our current house into a rental property! This is an exciting, but somewhat scary time for us...
Thanks for reading! Please feel free to comment below...