How to Diversify Your Stock Investment

One of the 'natural problem' in investing is the lack of certainty about the future, where even a very well established company could stumble on particular issues, having a bad financial performance, or even bankrupt. That's why in investing, the decision to place all available funds in a single asset/stock only, is not recommended, no matter how good the stock was. An investment policy to place the fund into two or more stocks, that’s what we called diversification. The question is, how do we do it?

Diversification is basically aims to reduce the risk of loss. If you use all of your funds to pick one stock only, then if it was a wrong stock, whether it's because of fundamental change or it was wrong from the beginning, then the value of the losses can be very large. However, if you spread the funds at ten different stocks, then it is virtually impossible that all of those stock were the wrong choices. Even though you are still lay about investing, there will at least one or two stocks that successfully generate profits, and it certainly reduces the risk of loss that may occur.

Meanwhile, if you are an experienced investor, then of ten stocks that you select, usually there are one or two of them which turned out to be wrong selections, but it's still better than if you were just pick one stock, then it was wrong. Warren Buffett once said in his annual letter that of four different stocks that he chose, only three of them that are successfully making profits, while the other one generates losses. But still, his overall performance was not bothered.

Okay, then how should we in diversifying?

To be honest, there is no standard formula or strategy in diversification. However, based on my own experience, your diversification strategy can be effective (related to its function to lower the risk of loss), if there is no particular stocks in your portfolio that have contributed too much to your overall investment performance, while on the other hand, there is no stocks that have virtually no effect at all to your overall investment performance.

For example, you have a fund of US$ 1,000, and US$ 700 of them were used to buy a single stock only, the A stock, while the remaining funds distributed to stocks of B, C, D, and so on. It was a wrong diversification strategy, because the weight of A stock is too large, that if your choice on the A stock was wrong, then your loss will still significant.

On the other hand, if you have a fund of US$ 1,000,000, and you buy a certain stock using US$ 1,000 only, then it is also a wrong diversification, because no matter the stock would gain 100% or down 90%, its effect on the overall portfolio will almost nothing. You can not proudly say 'I bought a stock, and now it's gaining two fold', if you bought it at the amount of one lot only.

But that's my opinion. Meanwhile, if we take the example of Warren Buffett, when he held his partnership for the first time in 1956, he did a pretty strict policy of diversification, where he bought 40s different stocks (at the time, there were about 800s registered companies in the US stock market). The reason is of course because he intends to reduce the risk of losses to as low as possible, where his famous rules: Never lose the money, has applied since he was very young (since he was 26 years old).

But about five or six years later, Buffett changed its policy, in which he stated that in certain circumstances, he may put 40% of his funds into a single stock only, although in practice, he has never did that. In certain years, Buffett put one-third aka 30 - 35% of the total funds under his management in just one stock, but never reach 40% or more.

This policy has made ​​Buffett is known as an anti-diversified investor. Some people think that the quote 'never place all your eggs in one basket', it was a quote of Warren Buffett, but it was not.

But note that even though Buffett refused the policy of diversification, that does not mean he's actually buy a single stock only, but he still has several different stocks in his portfolio, only at a less amount than the policy of professional investors in general. In 1956 until the early 1960s, Buffett held about 40 different stocks, but since 1962 until the mid-1980s, he had 10 - 20 stocks only.

While since the 1990s until today, Berkshire Hathaway holds more than 100 different stocks, either as a majority or minority shareholder, but that's not because Buffett returned to his old diversification strategy as when he was very young, but because of the gigantic-size of assets held by Berkshire, so it was almost impossible to place it all in ten or twenty companies only. Do you know what is the value of the total assets of Berkshire today? As of the third quarter of 2013, it was US$ 458 billion! With that money, you could buy all the shares in the Indonesian Stock Exchange, and you will still have the remaining cash of about US$ 100 billion.

Back to the matter of diversification. The question is, what makes Buffett refused the diversification? There are two things. First, based on his experience, when Buffett 'had' to spread his funds into 40 different stocks, then it will be difficult to find 40 stocks that are worth investing in Wall Street. Buffett always apply a strict investment criteria in selecting his stocks. Thus, from about 6,000 listed companies in the US stock market, he would find 10 to 20 stocks only that are worth buying, both in terms of the quality of company's fundamentals and the stock’s valuation.

So let say, when Buffett has only found 20 stocks that worth buying, then why he should buy the stocks number 21, 22, and so on, whereas these stocks are not worth buying?

Second, as we all know, the purpose of diversification is to reduce the risk of loss. While the strategy of value investing that is applied by Buffett, it also focused on efforts to reduce the risk of loss. So if the goal is 'not to lose', then a wide diversification is no longer necessary, because if the investors in question were already applying value investing appropriately, then he is less likely to experience losses.

And the fact is, if you’re holding too many different stocks, then you could confused by yourself, because it must be hard to intensively watched these stocks one by one, is not it?

Back to the question, is diversification necessary? The answer is of course necessary, as you you should put your investments in several different stocks.

But if the question is continued, what kind of diversification? Then the answer is a reasonable diversification, not a distressed one! You are advised to spread your funds in seven to ten different stocks, or a maximum of fifteen. From all your holdings, there are three to five stocks that became your main investments, where about 40 to 60% of the total assets placed in these main stocks. At least, that’s what I am doing.

About the ‘main investments’, remember that Buffett said that in certain cırcumstances, he may allocate up to 40% of his assets in a single stock only. Although in practice he never did that, but it shows that Buffett has always had a 'main stocks' in his portfolio, either just one or a few stocks, the which he put more money in these stocks than the other stocks in the portfolio of Berkshire Hathaway.

And the reason why Buffett has some main stocks/assets in his portfolio, is because he never had the same level of confidence for the stocks he held, just like us all, right? For example, you find two stocks that are worth for investments, ie stocks A and B, then after some deep analysis, you might assume that stock A has a better fundamental quality and also a better valuation than stock B, but stock B is also too good to be ignored. So of the two stocks, which one that became the main stock which you buy more? Stock A, of course.

However, to prevent these 'main holdings' do not give too much influence on the performance of your overall portfolio, then you better have more than a single stocks in your group of main holdings, let say three or five stocks, and it would be better if those stocks are from different industries. Remember that although in certain years, Buffett sometimes confident enough to allocate up to one-third of the assets of Berkshire in just one stock, such as Coca-Cola in the early 1990s, but Buffett is rarely do the same in other years.

On the other hand, you are advised to not buy a stock at a tiny amount, unless the stock is under accumulation (you're collecting them piece by piece). If you are interested in a particular stock, but you are not confident enough to buy it at a significant amount, then do not buy it! As a result, all the stocks in your portfolio are important, either included in the main holdings or not.

By this way, you will have a portfolio which there are no particular stocks in it that has a too large influence on the overall performance of your investments, but on the other hand, there are also no ‘nickel’ stocks that do not give any influence to your overall performance. And when you arrive at that condition, then your strategy of diversification is running effectively, and you no longer have to worry about one or two ‘bad stocks’ in your portfolio.

Well, that’s all from me about diversification. Now what about you?