The Power Of Portfolio Diversification

Portfolio Diversification - this is one of my favorite topic in investing.

Too many people, in the pursuit of making quick money - completely forget about portfolio diversification.

They ended up putting too much in a single stock - that's a sure-fire way to lose a huge chunk of your wealth.

Let me illustrate the power of portfolio diversification.

Making Money Even If
You Suck At Investing

Let me a paint a scenario, where you really suck at investing.

You invested in $10,000 into 4 stocks equally.

The stocks had the following performance over 10 years:

At first glance, this seems meaningless doesn't it.

Wouldn't it be a break even? Well, let's find out what happens across a 20 years time period.

Wait what...

Even though, the arithmetic sum of the gain/loss added up to zero - your $10,000 will still grow to $23,104.

Do you understand what this means?

It means that you can pick a few losing stocks, and yet still make money!

That's a 13.1% annual return - by the way.

Now, if that doesn't assure you...let's change the scenario a little.

Now, let's say you downright suck at picking stocks - and you picked two stocks that are losing 40% every single year.

Would that change the results?

What will your $10,000 become in the span of 10 years?

Let's find out.

Wow...are you surprised?

Even if you downright suck at investing, and you picked two stocks that are losing 40% every single year - your $10,000 still became $21,994 in the span of 10 years!

That's still a 11.9% annual return!

This is the power of portfolio diversification.

What's the Secret?

Well, the secret lies in long-term compounding.

Noticed that Stock C & D are silently compounding your wealth at a much faster rate, even though Stock A & B are losing money over the years.

Can you imagine if you locked in all your wealth in either Stock A or B?

That's why it is so important to diversify your investments - so that even if you have losing investments, you will still make money overall.

The good news is that you could pretty much avoid stocks like Stock A & B by following the 8-Point checklist, and making sure that you pay a reasonable price for these stocks.

Which is what makes the previous chapters are so important.

How To Diversify Properly

So basically what diversification means is how many stocks you should buy and how much you should allocate per stock.

The truth is there is no one rule of thumb.

Some may say that you should allocate no more than 10% in a stock.

Personally - I feel that the amount you should allocate really depends on your portfolio size.

The reason for doing so is because, with a smaller portfolio, your focus should be on growth.

And if you have a larger portfolio - your focus will be on protection.

If I had a smaller portfolio of around $10,000 or less, I would be more concentrated in my portfolio - say 30% per stock.

Now, 30% would mean $3000.

However, I don't enter all 30% at once - I will always enter in tranches.

I would split the $3,000 into three entries - $1000 in each entry.

The reason for doing so is so that if the stock price falls, I could lower my average cost with the subsequent entries.

(I will discuss the power of tranches in the next chapter.)

As your portfolio gets bigger, you want to balance between growth and protection.

With a portfolio of $100,000 - I would limit no more than 10% in each stocks.

This means the maximum of $10,000 in each stock.

With the three tranches rule - this means that I would only invest $3,333 per entry.

In order to accommodate to all my readers, here's a rough guideline that I have done.

So that, in a nutshell, is how I diversify my portfolio.

At the end of the day, before you invest - make sure you invest only in companies with strong financials and invest only when it is undervalued.

In our next section, we will go deep dive into the power of entering in tranches.