Diversification

Why does everybody keep stressing this???

Diversification is one of, if not THE, most important ways to lower your risk.


Think of the old saying "don't put all your eggs in one basket" - that is EXACTLY the benifits of diversification.


In the egg example, what happens if you drop that basket?  Ooh crap, broke all my eggs.  But if you split your eggs in 2 baskets, even if you drop one of the baskets: yaay, we can have omelettes still Tony!!


Now think of this with Stocks.  Owning one stock, and that could be good or bad, but you are leaving yourself open to a lot of risk (that might not even be predictable) - for example, what happens if a company gets sued?  Things could be going along great, and then BAM, donezo.

If you hold enough companies however, those risks tend to cancel out.  If one of the companies you hold is sued, perhaps another wins a lawsuit.  If oil prices going up hurts an airline company you hold, perhaps those oil prices going up helps an energy company you hold like a stock like XOM, or even an ETF like XLE (which is the SPDR ETF of the Energy sector).

The general rule of thumb is that you get the greatest benefits of diversification by adding early extra companies to your portfolio and there is a decreasing rate benefit as you add more and more... generally by about 30 companies you are fairly well diversified.   (That is, if these 30 companies are evenly distributed... as we saw with the example of the XLE ETF, they can all be focused around a sector, and then affected in the same way.  This concept is explored more in Factor-Models as well.


And wow.. listen to this compelling vision of the importance diversification plays as part of portfolio construction from Ray Dalio. 

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