Diversification in a retirement portfolio

I believed in diversification long before I had even heard the term. Owning more than just one or two stocks just intuitively seemed right, to me. And despite what you may have heard or read, building a diversified portfolio of about 25 individual investments is not difficult. In fact, capping your portfolio at no more than 25 investments can be difficult. 

Owning more than one or two stocks, spreads out risk. Owning more than 30 stocks risks diluting your portfolio with second string investments. It is easier to build a solid, successful 20 stock portfolio than one crammed with 40 investments. Less is more when it comes to portfolio building. 

 

There are three risks that immediately spring to mind when one is investing in the stock market: market risk, firm-specific risk, sector risk. Market risk cannot be avoided. The market goes up and the market comes down but, it goes up twice as often as it falls. Market risk fades with the passing of time. Given enough time the market will always graph as an uphill slope.

Firm-specific risk refers to the uncertainty of making money on any given stock. Try as you might, firm-specific risk is always with you. Think of Nortel. You do recall Nortel, don't you? It was said to be "too big to fail." It failed.

Lastly, sector risk applies to all the stocks trading in one sector. For instance, AltaGas, Enbridge, Pembina, and TC Energy are all pipelines. If sentiment turns against pipelines, it turns against all the companies in the sector. Recently, telecoms ran into a rough patch that affected all the players in that sector. BCE, Cogeco, Quebecor, Rogers and Telus all dropped in value. Some dropped more than others but they were all affected.

Increase the number of stocks in a portfolio, increase the number of sectors in which one is invested, even throw in an ETF or two or three into the mix, and one has cut both firm-specific risk and sector risk. If you are Canadian with most investment in the TSX, buy an ETF based on the U.S. market, like XUS, and you have reduced market risk as well.

How many individual investments should you own? Well, it depends a lot on who one asks. Some claim  as many as 30 stocks are required for proper diversification. Others say owning 12 to 18 stocks in adequate.

I believe a good rule of thumb is to own at least 20 individual investments, up to a maximum of 25, with no more than five percent of a portfolio dedicated to any one stock. Note, I said stock. ETFs are different. It is easy to have 15% of a portfolio in an Index ETF based on the U.S. S&P 500 like XUS. Buy XUS and you immediately have a well diversified investment made up of 500 U.S. large cap companies. ETFs by their very nature are risk-diluting through diversification.

A spreadsheet is an excellent way to track one's portfolio. I know TD WebBroker will allow one to download a spreadsheet of one's investments. I imagine most other brokerage houses have similar software available to those with self-directed accounts.

A downloaded spreadsheet is incredibly malleable. One can easily track the percentage of a portfolio that is invested in each individual stock. And one can group stocks together and calculate how much of a portfolio in invested in each sector.

If you have more than one portfolio, download each and then link all to one master spreadsheet.

A well diversified portfolio should deliver good returns with less risk. A good spreadsheet will tell you how closely you are adhering to your diversification plan.