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Here’s our Club Mailbag email [email protected] — so you send your questions directly to Jim Cramer and his team of analysts. We can’t offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries. This week’s question: Hi! Can you explain how someone can be over-diversified in their portfolio? Thank you, Kimberly S. from Massachusetts Diversification is key to the Club’s investing strategy, which is why we always tell members that their first $10,000 should go into a low-cost fund that tracks the S & P 500 index. Investing in the 500 biggest public companies across 11 sectors is a good way to quickly get diversified right from the start. Where your portfolio goes from there — the individual stocks that you handpick to invest in — is where the issue of over-diversification can come into play. There have been various arguments made over the years about the optimal amount of diversification. Some say 10 to 20 stocks will do the trick, giving you one to two stocks per S & P 500 sector. Others say hundreds of stocks are needed to achieve full diversification. At the Club, we’re more in that first camp. We own 31 stocks in all but two sectors: real estate and utilities. Jim Cramer thinks that individual investors should err on the side of fewer stocks so they can keep track of their holdings and be nimble if things change. Jim modified the old Wall Street adage of “buy and hold” to “buy and homework,” meaning we don’t buy stocks and then forget about them. He advises investors that each holding requires at least one hour per week of homework such as reading earnings reports and conference call transcripts. Don’t get too hung up on a given number of stocks to own because being mindful of how to go about diversifying your portfolio is going to be the key here. That’s because diversifcation is about owning various holdings that are minimally — even inversely — correlated to one another with the goal of always having something working even when other parts of your portfolio are taking a beating. You can own 10 stocks or 100 stocks, but if they’re all highly correlated, you aren’t really diversified — aside from maybe avoiding a blow up at one stock due to unique issues facing that company. Which sounds more diversified? Owning 11 stocks, one in each market sector, or owning 60 stocks all in the tech sector of the market? Anyone who has experienced a market rotation — when money flows from one sector to another — knows it’s the former that gets you through the turmoil without losing sleep or ripping out your hair. We’ve seen some rotations of late, and they have not been pretty. So, let’s set aside the idea of counting stocks as a means of determining diversification or over-diversification and think about it in a more holistic sense. Owning 11 stocks, one in each market sector may be a good idea. But given the S & P 500 gives more weight to certain sectors over others, you would want to adjust the weighting of each stock in your portfolio to suit your risk/reward tolerance. For example, Apple at nearly a 6% weighting and Nvidia with a nearly 5% weighting are our top two stocks holdings in the Club portfolio. We believe strongly in those two companies, but we are not the Apple/Nvidia fund. Our other 29 holdings have a role to play in our diversification, too, but not at the same level of exposure. This reminds me of something my Economics 101 teacher taught us back in college: When you’re trying to think about a given problem or scenario, it can help to consider the extremes. If we apply that to the concept of diversification, we would say we have an equity portfolio with one stock and are considering the benefit of adding another stock with as little correlation as possible. On the other hand, we might imagine a portfolio with 999 stocks and consider the benefit of adding one more. It’s pretty clear that as you increase the number of holdings — assuming you start out with diversification in mind and aren’t concentrating into one industry or sector of the market — you are going to see diminishing returns on the benefits to your diversification efforts. Going from one stock to two means that instead of 100% of my account riding on a given stock, only 50% does, assuming equal weighting to make the numbers easier to demonstrate. Going from 999 to 1,000 stocks would result in only a fraction of a percentage point change in exposure. No single person is actually following 1,000 companies. I only picked the number to emphasize the extremes. And as we stressed above, we don’t run an equal-weighted portfolio at the Club. In a hypothetical real-world example, if we say, we are going to increase our portfolio from 15 names — the upper limit of what we recommend for one individual to keep track of — to 20 names, we have to ask ourselves if the altered risk is worth the benefit. Assuming you abide by our rule of thumb to do one hour of homework, per week, per name, then adding five stocks amounts to an additional five hours per week spent staying on top of your holdings. For that, we are spreading out our bets more and now, assuming equal weighting, each name will account for 5% of the portfolio, down from the 6.67% weighting they would get in an equally weighted 15-stock portfolio. It’s a decent trade off but again, how much real-world benefit you get is going to depend greatly on what those new names look like versus the existing ones. If you already own Nvidia for example, and decide to buy Advanced Micro Devices — yes, you’re Nvidia exposure may drop to 5% from 6.67%, but your artificial intelligence-driven semiconductor exposure is going to increase from 6.67% to 10% since Nvidia and AMD are closely correlated. One bad comment on cloud spending, for example, would be expected to hit both names. Bottom line In our view, it’s less about there being a number of stocks that suddenly causes you to be over-diversified and more about conducting a cost/benefit analysis of adding a new name to your portfolio and considering the correlation that new name has to your existing positions. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
Here’s our Club Mailbag email [email protected] — so you send your questions directly to Jim Cramer and his team of analysts. We can’t offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries.
This week’s question: Hi! Can you explain how someone can be over-diversified in their portfolio? Thank you, Kimberly S. from Massachusetts
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