Traditional diversification advice dictates that individuals should own a wide variety of investments in their portfolio including a portion allocated to income vehicles such as bonds, a cash / money market position, and a minimum of 20 stocks. This post isn’t going to focus so much on the macro-level strategy of bonds/cash/stock, but will look at the number of stocks and ways in which capital can be allocated to them as a value investor.
There are two primary reasons to ensure a portfolio has adequate diversification. First, if any one company has a catastrophic event, we don’t want it to have a devastating effect on the investor’s entire portfolio. A 50% drop in a company’s stock makes a much bigger impact if it’s part of an equally balanced portfolio of 5 stocks, compared to another portfolio that holds 20. Secondly, various industries are cyclical in terms of their growth and by choosing to invest in companies from a wide range of different industries, it can serve to smooth our the ups and downs in an investor’s portfolio. Does it make sense to follow traditional diversification advice as a pure value investor? Let’s have a look.