Question

Diversification of a stock portfolio can normally be achieved by:

Select one:

a. a. owning 30 to 40 stocks in different financial sectors

b. none of the answers are correct

c. c. it is not possible to diversify stocks

d. answers a. and b. are corrcet

e. b. Buying an index fund such as in the S & P 500

Answer 1

Solution

Diversification of a stock portfolio can normally be achieved by :

• a) Owning 30 to 40 stocks in different financial sectors
• b) Buying an index fund such as in the S & P 500

d) answers (a) & (b) are correct.

Explanation

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Investors confront two main types of risk when investing.
The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification.
The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk.

Investors are unable to diversify away systematic risk, such as the risk of an economic recession dragging down the entire stock market, but academic research in the area of modern portfolio theory has shown that a well-diversified equity portfolio can effectively reduce unsystematic risk to near-zero levels, while still maintaining the same expected return level a portfolio with excess risk would have.
Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.
One need to diversify his/her stock portfolio across the board - not only different types of companies but also different types of industries. The more uncorrelated one's stocks are, the better.

The more equities you hold in your portfolio, the lower your unsystematic risk exposure. A portfolio of 10 stock, particularly those of various sectors or industries, is much less risky than a portfolio of two. Of course, the transaction costs of holding more stocks can add up, so it is generally optimal to hold the minimum number of stocks necessary to effectively remove their unsystematic risk exposure.
For investors in the U.S., where stocks move around on their own more (are less correlated to the overall market) than elsewhere, the number is about 20 to 30 stocks to be held in a diversified portfolio.
A well-diversified portfolio of randomly chosen stocks must include at least 30 stocks for a borrowing investor and 40 stocks for a lending investor.
More recent research suggests that investors taking advantage of the low transaction costs afforded by online brokers can best optimize their portfolios by holding closer to 50 stocks.

Buying an index fund such as in the S & P 500

In recent years, a lot of investor money has been flowing into index funds. Investors seem to love the low-cost nature of index fund investing, as well as the diversification and ease that comes with them.

Billionaire investor Warren Buffett has said that an S&P 500 index fund is the best investment most Americans can make.
He did'nt necessarily say that it's a bad idea to buy individual stocks if & only if one has the time, knowledge, and desire to do it right. But that is not always feasible.

Essentially, Buffett feels that an investment in an S&P 500 index fund is a bet on American business, which has historically been a very good one. Over the long run, the S&P 500 has generated total returns of about 10% annualized.
Since S&P 500 index funds generally have minimal fees, one gets to keep the vast majority of the returns. In a nutshell, an S&P 500 index fund guarantees that one will do as well as the market over time, which has historically been quite good.

What is an S&P 500 index fund?

An S&P 500 index fund is an investment vehicle, either in mutual fund or exchange-traded fund (ETF) form, that invests in the 500 stocks that comprise the S&P 500 index, in market cap-weighted proportions.

While fees vary, these tend to be extremely cheap ways to invest. As of this writing, S&P 500 ETFs can be found with expense ratios as low as 0.03%. This means that for every $10,000 you have invested, fees will only be $3 per year.

S&P 500 index funds are better as long term investment opportunity. In other words, if someone needs money within few years after investing, then he is better off looking elsewhere, such as a five-year CD or bonds.
The reason for this is that the S&P 500, just like individual stocks, can be quite volatile over shorter periods of time. Over the past 50 years, the index has gained 30% or more in nine separate years, but has also lost as much as 37% in a single year, even after factoring in dividends. However, over long periods of time -- say, 20 years or more -- the S&P 500 has never been a bad choice.

To illustrate this, let's say that one had invested $10,000 in a low-cost S&P 500 index fund in 1980. Since Jan. 1, 1980, the S&P 500 index has generated 12.1% annualized rate of return.

Assuming an expense ratio of 0.1% on a person's index fund, this means that a $10,000 investment would have turned into just over $760,000 as of Feb. 1, 2018.

This is why Warren Buffett recommends cheap index funds as an investment for the majority of Americans. Surely, one wouldn't have beaten the market, but one would have been guaranteed to do just as well as the market. An S&P 500 index fund would have allowed any investor to turn $10,000 into more than three-quarters of a million dollars in less than four decades -- with the bare minimum of effort and expense.