Highlights in this issue:

*** Why owning 100 different shares won’t help you one bit…
*** Why ten is an investor’s perfect number...
*** The best book I’ve ever read…
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From the pen of Karin Iten…

Dear Investment Academy Reader,

This might sound corny, but one of the best parts of my job is you – the readers. There’s nothing I like more than tackling your questions to make you better, smarter investors.

So today, I’m going to take a look at the crucial topic of diversification – how to invest your money wisely across a number of shares, so you maximize your profits for the least amount of risk.

Let’s get into it…

Whatever you do, don’t go buying loads of different shares!

Private investors are continually warned to diversify. The trouble is, the call to diversify is loudest when the market is down. This is the opposite of what you should be doing. In a bear market, you actually need to discriminate, be extra careful and extra discerning and not diversify just for the sake of it. (By comparison, in a bull market any old rubbish goes up – and so diversification can work for anyone. As they say, “a rising tide floats all ships”.)

Recently, even while the markets were falling, many shares have made big, big gains. There have been plenty of winning shares to choose from and the fact is, for a low-risk, diversified portfolio, you don’t actually have to own many shares.

Don’t let the fund managers fool you!

Here is the maths: Three things determine the risk inherent in your portfolio – how many shares you own, how much they swing around and the extent to which they all tend to move in the same direction at the same time. All this adds up to something statisticians call the “standard deviation” of your portfolio.

Basically, the higher the standard deviation number, the more the share fluctuates, and consequently, the higher your risk.

Now assume you own just one average share. If you add another share – in a different sector – the standard deviation of your two-share portfolio falls by a quarter. With five shares the standard deviation is two thirds of what it was when you started. And by the time you have ten shares, your portfolio is 40% less risky than it was.

Why owning 100 different shares won’t help you one bit

But now here comes the really interesting bit. The benefits of diversifying are good at the beginning, but soon start wearing off. If you have 100 shares the standard deviation is only 45% less than if you only had one share and even if you have 200, the risk factor is almost unchanged!

So, what does this actually mean for your portfolio? Assuming your shares are a reasonable mixture of sectors, all you need for a low-risk portfolio is a grand total of ten shares! And buying a whole lot more is going to achieve nothing in terms of reducing your risk, except a lot of extra work and dealing costs!  

Do you suppose your average fund manager takes notice of this? Well, find me a unit trust portfolio with only ten shares! Or a portfolio manager who actually realises when it comes to risk diversification, the law of diminishing returns kicks in big time!

I’m not afraid of the occasional loser. It’s happened, and it’ll happen again. But I want my winners to count and not to be lost in the morass.

Look at it this way. Start with ten shares.

Assume two double in price, two make 50%, you have one disaster that halves, and the rest go nowhere. Add it up and you make a 25% gain. Where else will you find those gains these days?

Bottom line: If you pick your shares carefully, a ten share portfolio gives you plenty of diversification. And there’s no way you need the services of a swanky fund manager!

Here’s to your financial freedom,

Karin Iten
for the Investment Academy