When you buy a coffee from your local coffee shop, do you secure it with a lid before getting in your vehicle? Do you fasten your seat belt before driving off?
It turns out that humans are inherently managers of risk, especially when we're aware of the potential consequences of our actions, such as the possibility of becoming a traffic statistic on an otherwise clear and beautiful day.
Every investor, whether he or she realizes it or not, is also a risk manager of an investment portfolio. Invest in a stock, and you've just created a portfolio -- and taken a position with respect to risk.
Diversification is the practice of spreading one's capital across a number of investments, as both a risk management technique, and a tool to enhance long-term investment returns. Diversification can be your best friend, but using it successfully takes a little more finesse than simply adding a slew of stocks to your brokerage account.
Treat the following two types of risk
There are two major types of risk the retail investor should understand when thinking about diversification: systematic risk and idiosyncratic risk.
Systematic risk is the risk that an outsize event might affect all assets in a particular market. For example, the failure of investment bank Lehman Brothers in September 2008 caused significant losses in the broader stock market. Systematic risk is also referred to as "market risk."
By this reasoning, allocating your entire investment capital to a basket of common stocks and/or similar instruments (like mutual funds and exchange-traded funds) creates systematic risk. Purchasing other assets, like bonds, precious metals, and real estate, can diminish systematic risk. Having said that, we'll focus below on diversification as it relates to a portfolio of stocks; just bear in mind that equities shouldn't be the only instruments you place your capital in.
Idiosyncratic risk, sometimes called "non-systematic" risk or "specific risk," pertains to risk specific to a single industry or asset. If the only stock an investor holds is the Kraft Heinz Company (NASDAQ:KHC), and a tomato shortage puts a dent in the company's earnings, the investor would then become a victim of idiosyncratic risk.
Keep an eye on correlation
Correlation is a measure of how closely two assets move in relation to each other in a given market. Stocks within a single industry are often observed to be correlated to each other -- in some industries more than others. For example, railroad stocks have very similar business models, and they tend to be highly correlated in their stock price patterns. So, an investor should seek to understand the degree to which portfolio holdings may show a tendency to fluctuate in tandem with each other.
Size can also be a factor in correlation. If an investor properly diversifies among industries, but only buys stocks that have a market capitalization of below $1 billion, those stocks can get hit if small-cap stocks as a group fall out of favor with investors.
How many stocks are appropriate to manage risk?
Generally, somewhere between 15 to 25 stocks is said to be an optimal level of diversification to manage risk. Keep fewer holdings than this, and you could be hit by idiosyncratic risk, or over-correlation between a handful of stocks.
Add much more than this number of equities to your brokerage account, and the complexity of managing your portfolio on an ongoing basis increases significantly, as well as the possibility that your returns will revert to the mean of the broader market. Some academic studies posit that as many as 50 stocks may be needed for proper diversification; however, this number is impractical for the average investor to manage properly.
It's a popular notion that buying a single exchange-traded fund that tracks, say, the S&P 500, is a way to diversify cheaply and efficiently across several hundred stocks. Just remember that such a strategy can still expose you to systematic risk, making it all the more important to consider allocating a portion of your money among different asset classes.
Become familiar with this important term
You can further optimize your chances of investment success by utilizing "beta," a central concept to diversification.
The market in aggregate is said to exhibit a price volatility, or beta, of 1.0. A stock with a "beta" lower than 1.0 can be considered less volatile and, by extension, less risky, than the overall market. The opposite is true if a stock has a beta above 1.0.
It's a good idea to evaluate the beta of each investment in your portfolio to obtain a global understanding of how aggressively you're positioned vis-a-vis the larger market. Also, in gauging the beta of your portfolio as a whole, be sure to take into account the relative weight of each position. Holding 10 stocks with an average beta of, say, 1.2 may not be so effective if 90% of your money is in stock No. 11, which has a beta of 2.0.
Why diversification can be your best friend: taking the reasoning a little further
In evaluating the beta of your individual holdings as well as your overall portfolio, you may come to realize that diversification is actually more of a risk adjustment or risk management technique than it is a risk reduction technique.
After all, there are some cases in which you'll want to increase risk or volatility through diversification.
For example, if you find that your positions consist of a group of non-correlated stocks, fairly well protected from idiosyncratic risk, but with an aggregate beta of just 0.5, it may make sense, depending on your investment goals, to begin to weight your portfolio toward more volatility, creating the potential for higher returns.
And speaking of practice, try making it a habit to take a fresh look at your portfolio each time you add or subtract a position. Tying together the concepts of systematic and idiosyncratic risk, correlation, and beta adjustment can give you more nuanced control over your investment destiny. Understanding why you're diversifying in a certain manner is always preferable to simply increasing the number of stocks you own.
Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.