The U.S. market as a whole has produced average annual returns of about 10% over the past century, but it doesn’t go up 10% every year. In roughly one out of four years, it declines — sometimes a lot.
History shows that markets bounce back. But enduring sickening declines isn’t easy. The best way to smooth the ride is through diversification.
The topic today is diversification in the part of your portfolio that consists of stocks and stock funds. The value of diversification seems awfully obvious. Morningstar data in June 2021 showed that about 39% of all U.S. stocks had suffered three-month losses of 50% or more, but fewer than 1% of diversified stock funds had incurred losses that severe.
How much diversification do you need? Certainly, owning an S&P 500 fund such as Fidelity 500 Index, which holds about 500 different companies and is weighted by market capitalization, will do the trick. Or, for super-diversification, there’s Vanguard Total Stock Market, an exchange-traded fund that owns 4,119 separate stocks.
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But what if you want to construct your own portfolio of individual stocks? A debate rages among economists over how many securities you need to get the benefits of diversification, ranging from at least 10 to as many as 50.
However, the number of stocks is only part of a diversification strategy. You have to diversify by sector, too. If all 30 of your stocks were in energy, for example, your annual average return over the past 10 years would have been a miserable 5.6%, compared with an annualized 13.9% for the S&P 500 as a whole.
The best way to stay balanced is to reallocate your holdings at the end of every year or six months. Sell shares of stocks that have grown sharply in value and use the proceeds to buy more shares of the laggards.
But diversification has costs as well. It dilutes strong convictions.
Andrew Carnegie, who in his day was the richest man in the world, disdained diversification. He said in 1885, “The concerns which fail are those which have scattered their capital, which means that they have scattered their brains also.”
Warren Buffett, the CEO of the holding company Berkshire, says that diversification “makes little sense if you know what you’re doing.” His company at the end of 2021 held 40 listed stocks, but 41% of those assets were in a single stock — Apple.
Most investors, however, are saving for a more comfortable life, retirement or security for their children, not to strike it rich.
In addition to owning broad index funds, you can get strong diversification through low-cost managed funds. Dodge & Cox Stock, for example, has a 74-stock portfolio and an annual average return of 14% over the past 10 years.
Owning a single fund with a great track record like the Dodge & Cox fund — or Fidelity Contrafund, which has a much larger portfolio, or even Parnassus Core Equity Investor, with only 40 stocks but a broad combination of sectors — is really all you need to achieve solid diversification.