What Is An Appropriate Amount of Diversification?
The fact that you're invested in a 401(k) plan gives you some level of
diversification, since mutual funds are by nature diversified, and a 401(k) plan gives
you several fund options.
We've seen that adding assets to your account reduces the amount to which your fortune is tied to the performance of any one stock or bond. We've also seen that when assets have a low correlation to each other, they can act together to enhance the value of your account.
But is there an adequate level of diversification? According to some financial experts, an
appropriately diversified portfolio -- one which gives you adequate risk reduction
while still holding out a substantial reward -- would contain about 30 securities.
But you can't really measure diversification by numbers alone. You also need to have assets with different characteristics -- for example, companies in different economic sectors -- to be truly diversified.
Here is an example of a stock portfolio that contains many different assets
without being diversified.
Let's say you put all your money into Sears stock. You don't want so much exposure
to one company, so you move half your funds into stock in Walmart. Seeking further
diversification, you really begin to branch
out -- Kmart, Target, JC Penney and so on. You could end up owning stock
in dozens of department store chains. This will reduce some
individual company risk, and since many of these chains are strong in certain regions,
it may reduce the risk of economic downturns in certain areas. But your investments will still rely too much on the performance of the department store market overall.
A portfolio can contain dozens of assets and not be diversified enough. Conversely, it can be
fully diversified with fewer than 30. If you choose investments with varying characteristics (such as different industry sectors, different asset types, etc.) it's possible to create a diversified portfolio without buying everything in sight.