With all the financial guidance hoopla focused on ensuring that you are diversified enough, it’s easy to forget about the problem of overdiversification.  I admit that it’s not something I’ve had to think too much about yet as I am still building my portfolio.  But it occurred to me today as I was doing some fall cleaning that having too much stuff makes decision-making more difficult.  If you have 50 options to choose from, you might be left with analysis paralysis.

On the other hand, if you have only four options to choose from, it’s much easier to make a decision.

This is why it feels easier to think in your office once it’s cleaned up and everything is off your desk or out of sight (much better if it’s truly organized and out of sight, of course).  Having stuff lying around is like having a hundred things on your mind at once.  Psychological research has shown that humans are capable of viewing and remembering (in short-term memory) only about 7 things at once.  It’s called subitizing.  Seven is the highest number we can subitize, that is, count visually at a glance.

So I’m thinking it might also help if you used that number seven and employed in in other areas.  Have no more than seven pairs of shoes of all sorts (men might need less), seven sweaters, seven pairs of pants, seven items on your desk, seven things on your to-do list.  Etc.  What do you think?  It’s worth a try.  The number might need to be adjusted slightly higher or lower, but if seven is some kind of natural visual-cognitive limit, it makes sense that it might function that way in other areas of our lives too.

How does this apply to stocks?  Clearly, it’s probably not going to be a good idea to keep only seven stocks if you’ve got a portfolio of $100,000.  But if you have too many stocks, it’s going to be more difficult to keep track of them (not insurmountable, though), and it’s going to take longer to make any one investment decision.  Some of the ishares ETFs only carry about 70 or so stocks.  These have professional managers working at the helm.  I’d advise that you probably shouldn’t carry more than 50 or so stocks yourself unless you can devote much, much more time to it.  I do know one millionaire who manages his own portfolio of more than 100 stocks.  I’m sure it’s doable, but at that point it’s probably a full-time job.

Just like clutter and clothes, you need to weed out the stocks that aren’t working for you anymore.  Check every two years.  Maybe you’ve learned more about your investment options and have thus expanded your working context.  You might know now that you don’t need a stock that you thought you needed.  Or you’ve learned more about one industry and now you know you don’t want to be a part of it.  Whatever it is, get rid of stocks that aren’t working for you - have they cut their dividends?  Are they looking for a buyer?  Is their industry dead?

I admit I haven’t mastered the art of letting go of stocks, however.  So far I’ve only been able to do that with Nortel, and good thing I did let that go.  It never recovered; it was a deadweight in my portfolio.

Are there any stocks you’re still holding on to because you are afraid to sell them?  What size of portfolio are you comfortable with?  I always like to hear another opinion.  Leave a comment below, and don’t forget to subscribe to my feed for more discussion.

So, I’m back from a business-related vacation and am catching up on some of my administrative and financial errands.  While thinking about making my next big investment purchase, I had a little insight about diversification.  I have no idea if this is genuinely “new” or not, but it is certainly a new way of thinking about it for me.

Usually diversification advice follows such guidelines as “never more than 10% of your portfolio in one stock” or “not more than 20% of your portfolio in one fund.”  Additionally, comments I read from other bloggers and friends online suggest that you want to have at least $500 or $1000 at a minimum in any given stock for it to be “worth it” (at least that’s the assumption that I’ve gleaned).  [Of course we all know that if you "DRIP" it's quite easy, feasible and even recommended to invest smaller sums than that (to read more of my thoughts and experience with dividend reinvestment plans click here).]

The thought that I’ve just had, though, as I sit here trying to doll out my investment rations, is that perhaps we should or could also think about diversification in relation to how much the given sum of money means to you.  If you make $40,000 a year and for some reason get an unexpected bonus or gift of $10,000 (a quarter of your salary), I’m guessing that chunk of change is going to be very meaningful to you.  You might really want to protect it and take advantage of receiving it all at once.  So naturally you might want to be extra sure you properly diversify so as to protect your principal as much as possible (even if you’re planning on investing for growth).  So you might want to “over”-diversify a bit just to be extra sure and feel as safe as is possible going forward.  Example: the 10% guideline would tell you to put $1000 (at a maximum) in each stock.  But you might feel more comfortable making that no more than $500 in each stock.

On the other hand, if you make $40,000 a year and receive a $1000 bonus or gift, it probably wouldn’t be as meaningful.  It’s less than a month’s salary.  You can “make it again” quite easily.  So you might feel even more comfortable taking that $1000 and putting it all into one stock.

What’s interesting is that in each scenario above, you still might be putting $1000 into one stock.  This does illustrate the relativity of perception surrounding the worth of money, and in both cases, the individual stock risk is going to be the same (if you invest $1000 in HippyTown Bank and they go under, it’s not going to matter whether you also have several other holdings or not).

Adjust your diversification requirements on the basis of what (or how much) the money means to you.

If one wanted to proceed strictly mathematically, the 10% guideline should be followed regardless of the size of your total investment.  But if you only have a bonus of $1000, that would mean putting $100 into each stock.  If one of those stocks crashed, you’d only be out $100 and if you’re making $40,000 a year that might not feel like much at all.  Hence considering moving the diversification guideline up a bit to take into consideration how much a given sum of money means to you.

I guess these thoughts build a little bit on what I was saying in a previous post about letting our emotions get involved in our investing.  We should take into consideration what any given sum of money means to us.  Of course money and currency are fungible (i.e., completely interchangeable) - one ten-dollar bill “is the same” as any other ten-dollar bill, but that’s comparing it to itself.  One ten-dollar bill is not the same ten-dollar bill to an investment banker as it is to a young student working for eight dollars an hour at a coffee shop.

What do you think?  Is this something you’ve already been putting into practice?

In my own case, the amount I’m investing is actually meaningful to me since I don’t often receive this amount all at once and I really want to make the best use of it.  I want to maximize my yield opportunity but not sacrifice proper diversification.  I haven’t made up my mind yet on which stocks I’ll put it in, but they’re going to pay me good dividends and they’re going to be somewhat conservative (as stocks go).

The answer to this question depends on who you’re talking to, of course. One author spouting ETF’s shows how, if you want to keep things really basic, you only need three ETF’s if they’re well chosen. A bond ETF, an S&P composite ETF, and some foreign ETF. Jim Cramer doesn’t do ETFs, he’s just into buying stocks directly - not DRIPPING, but just going through your seven-dollar-a-trade-broker and purchasing yourself. Cramer caps his own portfolios at 25 stocks. He says you need a minimum of 5 to be fully diversified, and that you need to spend an hour each week doing homework on that stock. So for most people, that limits their portfolios to about 10 stocks.

I disagree that you need to do that much homework each week on each stock. I agree that the quality and type of homework he recommends needs to be done, however. But for any given stock I don’t think you need to do that each week if you’re buying and holding.

Back to diversification, though. How much do you think is enough? I’ve only been in the investing game for a decade, but I can already tell I’m a pretty contrarian investor. I think alot of people like to think they’re contrarian investors, though. I can tell you I have more than Cramer’s 25 stocks, though! And I don’t think it’s too much. I’ll buy what I like. There are more than 5 sectors and there is more than one country on the planet. It’s good to spread your wings. Here’s my own recommendations for diversification:

I’d recommend at least 20 stocks for real diversification

• two oil stocks
• one oil-and-gas-industry related stock, like transportation or info services
• two financial stocks (banks)
• one insurance stock
• two foods stocks (big grocer plus a supplier, maybe)
• one healthcare stock
• two mining/resources stocks
• two transportation stocks (railways, trucking fleets)
• four foreign stocks (in a sufficiently different market correlation from the U.S.)
• one auto-manufacturer (that is already a leader and will be expanding into fuel-cell and hybrids etc.)
• two utilities (one local, one national)
• one telecommunications stock

I could go on and on. I don’t think 5 stocks are really enough, even if you are in 5 different sectors. You’d split up 20% to everything and if that one company does poorly, that’s 20% of your portfolio. (If you’re in ETFs, that’s different. 5 ETFs could be enough if you can sit well with a 100% ETF strategy.) At 10 stocks, you’d still have 10% on just one company, and that goes contrary to many recommendations about only keeping maximum 5% in one company. For that, you’d need 20 stocks.

I don’t always plop down a big amount on each new stock acquisition. Sometimes it’s rather low and makes the commission look horrendous. Right now, that doesn’t bother me. I’d rather know I’m well-diversified.