67% of the FTSE With Just 5 Shares

LONDON -- A couple of articles that I've written recently have prompted a debate among some readers -- even among those holding only FTSE 100 stalwarts. In short, to what extent should you diversify?

At first glance, the question seems odd. Again and again, investing beginners are told that diversification is good.

But is it? As I wrote the other day, under-the-radar investment legend Seth Klarman currently has 40% of his $2.9 billion portfolio in just three shares.

Nor is Warren Buffett a fan. "Do not put your eggs in many baskets," he's on record as saying. "Put all your eggs in one basket -- and proceed to watch that basket very carefully."

Growth investing
The trouble is that I reckon the question itself is flawed. For asking the question, "How much diversification is enough?" omits any consideration of the investors' objectives.

A gung-ho capital-growth investor, for instance, will almost inevitably want to minimize diversification so as to maximize investment gains. If a share doubles in value and it's only one of 20 that you hold, then the overall impact on your portfolio is a gain of 5%. If your portfolio is 10 shares, the same doubling gives you a 10% gain overall.

Go the whole hog and put all your eggs in one basket, and the doubling of that single share represents a portfolio growth of 100%.

Dividend investing
Income investors approach things from a different perspective, though.

With a one-share portfolio, a 50% dividend cut in a single share reduces annual income by 50%. With a five-share portfolio, a 50% dividend cut in a single share reduces annual income by 10%. But with a 20-share portfolio, a 50% dividend cut in a single share reduces annual income by 2.5%.

I know which I prefer. My own income portfolio, for what it's worth, stands at 15 shares -- about halfway to the eventual number that I want.

Sector safety
That said, investors pursuing a cautious, in-between strategy -- dividends are good, but so are capital gains -- can more safely concentrate their portfolios by avoiding sector duplication.

Hold one bank, not two, in other words -- no matter how appealing the financial sector is. Ditto oil companies, supermarkets, pharmaceuticals, and so on.

67% of the FTSE
What might such a portfolio look like in practice? Take a look at this selection of five picks, each one chosen for reasonable fundamentals, reasonable prospects, and limited overlap with the other sectors.

Now, five sectors won't cover the full range of the FTSE by any means. Even so, the sectors I've selected, in fact, amount to an impressive 67% of the FTSE All-Share index. And viewed as five individual shares, they collectively make up 19% of the FTSE 100.

How diversified are they? Granted, "limited overlap" has, well, limitations. A recession, for instance, bites hard into consumer purchasing power, affecting every sector that is dependent on consumer discretionary spending. Even so, the products that these businesses sell for the most part fall firmly into the "nondiscretionary" category.

• Royal Dutch Shell operates in 80 countries around the world, operating more than 30 refineries and chemical plants and producing 3.2 million barrels of gas and crude oil each day. Global revenue amounted to $470 billion during 2011 -- some of which came from the company's 43,000 retail filling stations around the world, of course, but also from industrial customers of its chemicals and gas businesses.
• BAE Systems has expanded far beyond its aerospace roots to become something of a defense-related one-stop shop, with military aircraft, surface ships and submarines, tanks and other combat vehicles, ordnance, electronic warfare, and missile systems all on offer. The bulk of the company's sales goes to the governments and defense ministries of its five "home markets": Australia, India, Saudi Arabia, the U.K., and the U.S.
• Two billion consumers use a Unilever product every single day; the company's products are sold in more than190 countries worldwide. And those products are themselves almost perfectly diversified, both by geography and type (foodstuffs, cleaning products, oral care, personal hygiene, etc.). Sales of Unilever's clutch of global brands come 33% from the Americas, 29% from Europe, and 38% from Africa and Asia.
• GlaxoSmithKline isn't just the world's second-largest pharmaceutical company, employing around 99,000 people and manufacturing almost four billion packs of medicines and health-care products every year. It's also a consumer business with a robust collection of strong brands: Ribena, Horlicks, Lucozade, Aquafresh, Sensodyne, Panadol, Tums, Zovirax -- and, of course, the Macleans range of toothpaste, mouthwash, and toothbrushes.
• HSBC serves about 60 million customers worldwide through 6,900 branches and offices in 84 countries. With a strategy of being "the world's leading international bank," HSBC has the distinction of having paid out more in dividends than any bank in the world over the past five years.

Further reading
Want to know more? Two of these shares, as it happens, are profiled in a special free report from The Motley Fool -- "Top Sectors for 2012" -- which pinpoints 17 shares across three sectors tipped for outperformance. Reading it could throw a few more diversification ideas into the mix. As I've said before, I made two purchases after reading the report -- one of which is listed above. The report is free, so why not download a copy? It can be in your inbox in seconds.

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

More investing ideas from Malcolm Wheatley:

• 3 Ways You're Going To Lose Money
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• 5 Manufacturers Set For A Fall