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28-07-2023, 10:04 AM
Suppose you have $30,000 and you invest it all in stock A.
There is no guarantee that in one year’s time stock A price will go up. If something happens to the company and the business tanks and goes bankrupt, you would lose $ 30,000.
Now instead of putting all the money into one stock, you divided it equally to stock A and B in completely different industries. Then unless the business of stock A and B tank at the same time, you will not lose all the money. If stock A tank only, then you lose $ 15,000.
Imagine dividing the $30,000 into 30 stocks in completely uncorrelated industries. You will invest only $1,000 into stock A. So if stock A tanks, your loss is limited to$ 1,000. If the 30 stocks are not in related sectors the chances of all 30 of them going bankrupt is very very very small. So you reduce your risk of losing all your money.
I never said that you will not lose some. Just that you won’t lose all.
The problem with diversification is that you also reduce the chance of making a big $ gain as the amount invested in each stock is much smaller if you have more stocks in the portfolio.
In the above example, you can see that if A has a 10% return, if you had invested $ 30,000, you will gain $ 3,000.
However, if you have invested $ 1,000 you will only gain $100.
The diversification theory works only if all the stocks are not correlated ie the business prospect in one sector is not affected by another.
But it is a powerful concept so that there are benefits even if the stocks are partly correlated.
Modern Portfolio Theory divides the risk of any loss in a company into 2
Modern Portfolio Theory can mathematically show that the benefits of diversification become marginal after 30 uncorrelated stocks.
In other words, you can “get rid” of the risk associated with the individual companies as one loss will be offset by another gain. But you cannot get rid of the risk commonly associated with the external factors as this affects all companies even with diversification.
For more risk insights go to How To Mitigate Risks When Value Investing
There is no guarantee that in one year’s time stock A price will go up. If something happens to the company and the business tanks and goes bankrupt, you would lose $ 30,000.
Now instead of putting all the money into one stock, you divided it equally to stock A and B in completely different industries. Then unless the business of stock A and B tank at the same time, you will not lose all the money. If stock A tank only, then you lose $ 15,000.
Imagine dividing the $30,000 into 30 stocks in completely uncorrelated industries. You will invest only $1,000 into stock A. So if stock A tanks, your loss is limited to$ 1,000. If the 30 stocks are not in related sectors the chances of all 30 of them going bankrupt is very very very small. So you reduce your risk of losing all your money.
I never said that you will not lose some. Just that you won’t lose all.
The problem with diversification is that you also reduce the chance of making a big $ gain as the amount invested in each stock is much smaller if you have more stocks in the portfolio.
In the above example, you can see that if A has a 10% return, if you had invested $ 30,000, you will gain $ 3,000.
However, if you have invested $ 1,000 you will only gain $100.
The diversification theory works only if all the stocks are not correlated ie the business prospect in one sector is not affected by another.
But it is a powerful concept so that there are benefits even if the stocks are partly correlated.
Modern Portfolio Theory divides the risk of any loss in a company into 2
- those due to individual company problems eg mgt problems or specific product problems
- those of the general external factors eg economy or politics
Modern Portfolio Theory can mathematically show that the benefits of diversification become marginal after 30 uncorrelated stocks.
In other words, you can “get rid” of the risk associated with the individual companies as one loss will be offset by another gain. But you cannot get rid of the risk commonly associated with the external factors as this affects all companies even with diversification.
For more risk insights go to How To Mitigate Risks When Value Investing