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Diworsification: what is it and why should you care?
The issue with spreading yourself too thin
Dividend Dominator
September 30, 2024
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Happy Monday!
Let’s start the week off strong.
The agenda for today:
👉 Diworsification: What is it and why should you care?
👉 Whiskey: A Hedge Against Market Volatility
👉 Stocks: How many should you hold?
"Regardless of what happens in the markets, stick to your investment program. Changing your strategy at the wrong time can be the single most devastating mistake you can make as an investor."
Diworsification: what is it and why should you care?
The term diworsification was originally coined by Peter Lynch in his book “One Up Wall Street”
P.S. if you haven’t had the chance to read the book, I suggest you do.
Diworsification is a play on the word “diversification” and it’s the process of investing in too many assets with similar correlations, resulting in an averaging effect across the portfolio.
In other words, it happens when an investor adds stocks to a portfolio in a way whereby the risk/return trade-off is worsened.
Let me be clear, diversification is an important strategy.
Spreading funds across traditional asset classes like stocks, bonds, real estate, and cash means you’re not “putting all of your eggs in one basket”.
However, investors have taken this to an extreme, especially after the 2008 recession in efforts to spread their capital across many different areas.
Over-diversification, or “diworsification” is now common practice as a result.
Ever Heard of Risk?
Total risk has two components:
Systematic risk
Unsystematic risk.
Systematic risks are risks that cannot be mitigated through diversification. This includes geopolitics, and macroeconomic factors like recessions, inflation or interest rates.
Unsystematic risks are specific to individual companies or sectors and can be reduced through diversification. Examples include risks associated with management, strategy, business models, financial structures and operations.
By investing in a mix of assets from various sectors or with different business models, you can reduce unsystematic risk as the number of stocks in your portfolio rises.
But this only goes so far…
As the number of stocks increases, the amount of unsystematic risk you’re diversifying away slowly falls.
Until eventually every additional asset you own no longer benefits you as an investor.
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How many stocks should you hold?
While there isn’t a one-size fits all answer to this question, experts suggest you should hold around 20-30 individual stocks, which is the optimal number for balancing risk and reward.
But this can change drastically depending on how much you have invested.
Example 1:
John has $1,000 invested in the market.
How many stocks should John own?
Not an easy answer.
But if you said 30, John is probably spreading himself too thin.
Which is another issue with over-diversification.
If spread out evenly, this amounts to only $33.33 invested in each stock.
When you spread yourself too thin, you miss out on the gains of a few companies that may be performing well because your capital is allocated elsewhere.
Example 2:
Jacob has $1,000,000 invested in the market.
How many stocks should Jacob own?
Again, not an easy answer.
But if you said 30, you’re closer to the right answer than in example 1.
Why?
Because Jacob has 1,000x the capital invested than John does.
Which means the amount allocated to each position is significantly larger.
Which means his exposure to any gains (or losses) is amplified.
Here’s the thing…
The amount of stocks you own is also dependent on how much you have invested.
I posted the below tweet this past week and the response was accurate.
A sign you're a new investor:
You own 0.5 shares of 300 different stocks.
Stop spreading yourself so thin.
— THE DIVIDEND DOMINATOR (@TheAlphaThought)
11:59 PM • Sep 23, 2024
Spreading yourself too thin is a bad investment decision.
In the early stages, concentrate your portfolio into 3-5 high quality stocks and ETFs.
When you start accumulating more money in your account, only then should you consider adding more positions.
Instead of wanting a slice of every pie on the shelf, buy bigger pieces of the best selling pies.
That’s how you make money in the stock market.
See you in the next one!
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