It is a common strategy in the stock market to diversify your bets on stocks that you want to buy. The reasoning is widely called a reduction of risk. The saying goes “Never put all your eggs into one basket”. Let’s see what this strategy is all about.
Diversification of stocks
The trick is to buy so many different stocks (that means parts of companies) or bonds that the risk that one is failing will not have much effect on the general outcome and total value. So, imagine, you have bought 30 different stocks for 1.000$ in your portfolio and one company goes bankrupt. Does it matter?
One company goes bankrupt
When this company goes bankrupt, that stock price will go to 0 or the trading will be suspended. Nobody wants to be an owner of the company. But your overall portfolio value is not 0. You still have 29 * 1000$ = 29000$ of value and you still have the chance that those other 29 stocks increase in pricing and win back the failure of one company. In this case those other stocks need to grow at a total percentage of ~3,4% to come up for the loss of that one company.
How can you influence that?
It all depends on the stock picks. These are the possibilities:
- If you pick and buy your stocks in an intelligent way, you can make a win of much more than 3,4%. All investors in the world think they can do it. Be aware that That is not true.
- If you pick and buy your stock randomly, you will have a random outcome. Randomized, I’d consider sticking to the mean of all general “better” stocks, which are inside the big indices (like Nasdaq or Dow Jones). That can be well about +20% or -20% in a good or bad year. In the long run, there is growth.
- If you have no clue and buy the worst stocks possible or at the worst possible prices, you will lose with the 29 other stocks as well. (Not everything, but a loss is certain)
We can see that the diversification portfolio style can reduce the risk of total failure, but the reason is not what you thought. The reason is your own intelligent behavior in investing. One must be confident and intelligent enough to make good picks at the right prices. Randomizing can also make you win, but you don’t need to be a genius. A monkey can win with randomizing.
Diversification of bonds
It might be not easy to pick the right stocks in the market, but what about bonds? There are different risk levels for bonds and they have a defined outcome. Low risk bonds mean low interest rates, which means that you don’t need to diversify those. So, in this heavy diverse portfolio strategy you could mix low, mid and high-risk bonds. High risk bonds make the biggest trouble in the world. Imagine a country is bankrupt and you won’t get your interest or even your money back, because you have lent money to that country by buying bonds. That bond has failed. You won’t be the only one. It will certainly become a political issue. It can result into wars and many other unimaginable outcomes for the population. Mid or low risk bonds bring lower interest, but in a more certain way and with less trouble. At least some interest is better than nothing.
Questions are:
- Why would you mix high, mid and low risk bonds, when you can have only low risk bonds?
- Who knows which bond has a low risk? (Certainly not these guys)
Fees
Another big impact on this strategy are the buying and selling fees. These can be as much as 3% when you purchase lower amounts of stocks. So, for whatever stock buying order you set, you need to calculate in a determined loss of 3%. Let’s see the calculation with a 0,25% initial buying fee and that 30.000$ budget:
One-time purchase of one stock:
0,25% of 30.000$ + one-time order fee 20$ = 95$
30 times purchases of different stocks:
(0,25% of 1.000$ + one-time order fee 10$) * 30 = 375$
Same goes for selling! That means the fees are doubled.
With the first strategy (one-time purchase) you have costs of 0,4%. With the diversification strategy you have costs of 2,5%. That means with a diversified strategy you start with almost 1 pick of companies failing right away. That is your price or safety to have certain losses when you keep this 30 stocks strategy going and you are not good at stock picking or finding the right buy price. You must be much better in stock picking, buying, holding and selling than with the one-time strategy to have a similar outcome. That’s just for the initial cost.
Who can profit from this strategy most certainly?
Well, clearly the Bank and the Broker are the winners. They make a rough 675$ out of your orders, whether you are successful or not. Additionally, you have the 3,4% needed growth factor in case of only one failing company. That brings it up to 5,9%.
What does that mean?
It means: If you have no clue, it is safer to leave your money in your bank account and do nothing! I would argue that the chance that a total beginner without much idea can come up with 29 stocks that have a mean growth of 5,9% to only achieve a break-even is very low. On the other hand, one-pick is the all-In strategy, which takes a very good preparation.
Also, it brings up one big question. Where have you heard or read about the strategy of diversification before? Think about it. I might be related to Risk & Chances, but certainly investing is not a determined game.
Summary
The ability for clever picking and buying with this strategy is not less important than with other strategies, it is even more important. The fees are multiplied by the number of stocks you buy and much higher than with one-time purchases. A mix of both strategies for a beginner might make sense. There is, however a way to save many of these fees and increase the final outcome. (See e.g. ETFs)