The Importance Of Diversification

Not diversifying your stock purchases is similar to betting all your money on one number at the roulette table. It’s exhilarating and you might win big but chances are you won’t. The stock market is a zero sum game meaning that not only are we competing against investors such as ourselves but also against professionals trading for a living. These professionals have access to super computers and “inside information”. The thought of an individual investor such as ourselves beating the game is nothing short of delusional. We wouldn’t dare compete with an accountant or a lawyer in their fields when we’re artists right?

If the entire stock market consists of 100 companies and you have £100 to invest, it’s generally best to invest £1 into each of the 100 companies. Large companies generally make investors money via capital appreciation of their shares and dividend distributions and therefore if you hold all companies in your portfolio chances are you’ll ride their success tide. Additionally if one company goes bust, this will hardly affect your finances.

In reality every company has different characteristics such as varying earning potentials and size. If company A is twice as big as B then theoretically you should invest twice as much in A as you would be in B.

Something that’s becoming increasingly popular is the all-in-one index tracker fund, which is essentially a product you can purchase from a broker that automatically divides your invested amount into proportional amounts towards the specific market you’re targeting. This is a form of passive investing and the crucial advantage of passive investing is that your investment costs are minimised. Remember that keeping your costs to a minimum and tax efficient investing is an integral part of our strategy.

You’d be forgiven in thinking that very large companies are guaranteed investments and therefore picking one or two of your favourites is sufficient. However I remember when I was 15 or 16 when the supermarket giant Safeway that my parents bought our groceries from disappeared overnight and was replaced by Morrisons.

If Safeway only constituted 0.5% of your portfolio at the time then I doubt you’d lose sleep even if its shares went to 0. If you held only Safeway then you would’ve lost a lot of sleep!

I’m not entirely sure what happened to Safeway shares but regardless I’m sure you get my point.

As always, do your own research.

P.S. I learned everything I know about finance from this book, this book and that oneamongst many others. For a more extensive list, don’t hesitate to drop me a line at rory@ukdoctoronfire.com. If you prefer learning through listening use this link to earn a free audiobook of your choice by signing up to their 30-day free trial. Simply cancel with the click of a button if you decide later on that the service isn’t for you, no questions asked.