Diversification

The key to a successful investment program is diversification. Investment typically involves risk-taking and diversification is a spreading of the risk. You do this with investment in securities or inst5urments that aren’t positively correlated with each other. For examp0le, Ford and GM tend to have correlated results - -- when consumers are buying cars both manufactures willtend to do well. So a portfolio fully invested in some combination of stocks in those two companies is not diversified. But the performance of GM and Humana probably don’t tend to follow each other, their personance is pretty much unrelated. So a portfolio evening divided between GM and Humana stock is said to be diversified.
There are multiple dimensions of diversification
1. Sector diversification (automotive, transportation, energy, etc).
2. Geographic diversification (international
3. Income certainty (fixed income v. growth v. speculative)
4. Actiive management v. program trading
5. , Large cap v. small cap
6. Term diversification

Too much of a good thing
Mathematical research suggests that an ideal level of diversification is a portfolio of between 25 and 30 uncorrelated investment instruments. More than that doesn’t really tend to reduce your risk much, since the likelihood that an additional investment will correlateat least somewhat with an investment already in the portfolio is fairly high.
But empricial evideince – looking at actual performance of real investors – suggests that improvement in results peaks out after somewhere between 5 and 9 investment instruments.
The reason for that is probably that competent active management can yield a meaningful improvement in both risk and return but the human brain doesn’t really do well
with more than about 7 independent pieces of information. We can’t really follow more than 5 to 9 uncorrelated investments in a portfolio.
How much diversification is enough depends on hw much effort you’ll be putting into active management of your portfolio and how good you are at that task. The more efforts, and the better you are at it, the closer you should limit the number of investment instruments to about 7 – it you’ll be passively managing the portfolio you should spreaqd your investments over about 25 instruments.
If you’re going to be paying close attention to your portfolio performance then go ahead and put your eggs in just a few baskets.
Chapter 1. Sector Diversification
Some sectors
Automobile
Energy
Business Services
Retail
Technology
Housing
Health Care
Recreation
Financial
Government
Basic materials and commodities
Transp;ortation
Utilities
Food and agriculture
Consumer products