Diversification does not necessarily mean having a huge number of stocks in your portfolio. Investors often construct stock portfolio with 40-50 stocks (or more than that) to diversify their portfolio. If you are one of them then you are committing a great mistake at the very beginning. A portfolio of 80 stocks may not be properly diversified where as a portfolio of only 10 stocks may be properly diversified. Let’s take an example to clarify this statement. In the following example I am considering two stock portfolio with the following stocks-
- Portfolio 1 (23 Stocks) :- HDFC bank, ICICI bank, Axis Bank, State Bank of India, Bank of Baroda, PNB, ITC, Hindustan Unilever, Marico, Dabur, Colgate, Emami, Britannia, Tata Motors, Maruti Suzuki, Ashok Leyland, M&M,Bajaj Auto, DLF, Unitech, Sobha Developers, Oberoi Realty.
- Portfolio 2 (10 stocks) :- HDFC bank, ITC, Sun Pharma, Maruti Suzuki, Oberoi Realty, L&T, Reliance Industries,TCS, Tata Steel, Bharti Airtel.
Have a close look on both the portfolio. First one have 23 stocks and the second portfolio have only 10 stocks. Now tell me which one is more diversified?
First portfolio has 23 stocks but all those are from 4 different sectors(banking,FMCG,Auto and realty). Second Portfolio has only 10 stocks but from 10 different well-known sectors.So, obviously the second portfolio is more diversified.
In any economic downturn 1st portfolio will be affected the most. Banking,auto and realty all those 3 sectors will hurt first in economic slowdown and majority of “Portfolio 1 ” stocks are from those sectors. At the same time second portfolio won’t be affected much as there are 10 different sectorial stocks. It is unlikely that all those 10 sectors affect at a single time. Even if you follow any bear market you will find few sectors always outperform others.