First and most importantly, the investor needs to move beyond the simple notion that diversification is reached after a certain number of securities are held within a portfolio. You always hear magic thresholds of diversification, 15 or 20 stocks being the most cited. Unfortunately, these simple numbers fail to serve as a useful guide. For example, four stocks each from a different sector of the economy constitutes a more diverse position than twenty stocks in the same industry. The number of securities is not irrelevant, it is just a secondary consideration.

That myth aside lets break down diversification.

To start with, what makes diversification so important and desirable? Why not just invest all of your money in the industry you think has the most potential? To answer this we need a bit of investment theory. Recall that over the long term investment return is directly related to the associated risk. Therefore, there must exist some additional reward for taking on additional risk. Until this point we discussed the risk of asset classes, (stocks, bonds, etc) which is simply the average of the securities in that class. Instead, take a look at the risk of an individual security. This risk is composed of two components, the market risk and the security risk. The market risk is associated with the overall movement of the market, as broad market movements provide the most impetus for individual security movement over the short term. The risk of the company, and the industry associated with it, comprises the second component of the risk. The possibility always exists that an industry's product will become obsolete, even if the market continues going up, thus hurting all of the companies within that industry. Now consider two portfolios, A and B, each with twenty stocks all of which have the same individual security risk. Now assume portfolio A consists of twenty stocks in one industry, whereas B has twenty stocks from twenty different industries. As a composite each of these portfolios has the same expected return (equal individual security risk), but they do not have the same risks associated with them. The first portfolio still has market and security risk, but the second only has market risk. Diversification has eliminated the security risk. To prove this proposition take an example. Suppose, for simplification, the economy is composed of two industries, the oil industry and the airline industry. Then portfolio A has twenty oil stocks and B has ten from each industry. Next, suppose that oil prices crash, as they did during the winter of 97-98. The oil stocks will get hurt by the cheaper oil prices, but the airline stocks will benefit through less expensive fuel. Obviously, portfolio A will suffer, reflecting the security risk of an all oil portfolio, however B is left unaffected, as the oil stocks dip is compensated by the airline stocks rise, and thus will move only with the market. The security risk in B cancels out! Since A and B have the same expected return, this example shows that security risk is not rewarded, as it can be eliminated without reducing the expected return. As only market risk is rewarded, there is no reason to subject your portfolio to unnecessary security risk. The graph on the right depicts the situation. The blue line and green shaded area show all combinations of risk that produces a given rate of return. Portfolio B is diversified and thus takes on the least risk to achieve a particular expected return. On the other hand A takes on additional risk, in the form of security risk, but receives no additional return. As an investor, make it your goal to select portfolios on the blue line, the efficient portfolio frontier, to maximize your return and minimize your risk.

So we need to modify a statement made previously. Investors should maximize the market risk, not the company risk, of their portfolio subject to their risk tolerance.

Ok, how does an investor properly diversify? Simple:

Diversify globally, inter-industry, intra-industry.

The US share the world economy continues to diminish. Not that this is bad; it just reflects the fact that many emerging markets are becoming more and more important. With this in mind, investors need to recognize the importance of investing globally, especially in emerging markets. While this may prove hard to swallow during global fluctuations, emerging markets can actually help you lower your risk profile. Similar to the example of the oil and airline portfolio, investing in countries that move differently, like the US and emerging nations, can help you increase your returns and lower your risk over the long term.

On the domestic side, make sure you balance your portfolio with industries that will react differently to new economic circumstances. Twenty industries in the technology sector fails this requirement. Recognize which industries benefit during different segments of the economic cycle and make sure you have exposure to each. For example, housing construction benefits when interest rates are low and housing purchases are attractive. This will tend to happen at the start of an economic boom.

Finally and often overlooked, diversify intra-industry. Just because you own a stock in each of twenty industries does not mean you are fully diversified. Companies in each industry will take different technological approaches to tackle the same problem. Take the cable industry, for example. A split between traditional hard line cable operators and the satellite TV companies has developed recently. Avoid betting on which technology will eventually prevail. Instead, divide your investment in that industry between the competing technologies.
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