Why does it matter? Two reasons:
- All these people have their eggs in too few baskets. If one basket breaks, that can have a big effect on their total investments.
Number crunching by Whakatane sharebroker Brent Sheather on the downfall of Feltex shares shows this dramatically.
Let's say you own ten shares, including Feltex, with 10 per cent of your portfolio in each share. And let's say the other nine have performed the same as the sharemarket index. In other words, they are average performers.
In the year ending June 30, your total return would have been 12.7 per cent, says Sheather. Without Feltex, though, it would have been 20.7 per cent.
Having one poor performer has made a huge difference, even in a 10-share portfolio. With a smaller portfolio, it's even worse.
If you had equal holdings of Feltex and four other shares with average performance, your return would be just 4.7 per cent, compared with 20.7 per cent, says Sheather.
And if you half your portfolio was Feltex and half another share, your return would plunge to minus 19.3 per cent. The poor sods whose only share is Feltex faced a loss of 59.3 per cent.
- If you don’t diversify, you are taking risk for which you won’t be rewarded. Who needs that?
Most people know that risk and reward tend to go hand in hand. And that's not by accident.
With fixed interest investments, a riskier company will have to pay a higher return to entice people to invest in it.
With shares, people are more reluctant to invest in Risky Co than in Safe Co. That reduces demand for Risky shares, which in turn lowers their price. And the return on any low-priced investment has more room to grow if things go well.
The same holds for property. People won’t be as keen to buy a building in an area that might prosper but might not. Again, this pushes down its price and pushes up the possibility of a big gain.
In all these situations, market forces dictate the relationship between risk and return.
Such forces don’t work, however, when we're talking about the risk you take when you hold only a few shares.
Let's say you hold shares in just three companies A, B and C. On those particular shares, your return will be identical to that earned by a big investment fund that holds the same shares [dash] even though it also holds shares in companies D through Z.
You don’t get rewarded for taking the risk of being undiversified.
The message is clear. Two shares are much better than one; ten are much better than two; and so on, up to 20, 30 or 50, depending on which expert you talk to.
After 50 - as long as your shares are in a wide range of industries, countries and company sizes - there is little to be gained from further diversification.
Note, too, that it's better if your holdings in the different companies are roughly equal. If one or a few shares dominate your portfolio, the others won’t help much if the dominant ones perform badly.
If you haven't got enough money to spread your share investments widely, you will probably be better off in a low-fee diversified share fund.
