How To Build a Stock Portfolio

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Video Transcription:

Hello traders! Welcome to the stock trading course and the 7th Module, Building your Stock Portfolio.

In this lesson we’re going to talk about the dangers of over diversifying your portfolio. And I think I’m going to start by defining what over diversification is. Building a stock portfolio gives us the advantage of diversification thus controlling our risk in the markets. Our personal portfolio must be diversified to avoid the risk of holding just one stock. But over diversifying your portfolio is also a risk for investors. Now what is diversification? It’s simple. Diversification it’s the attempt by the investor to reduce risk by investing in various companies across different sectors.

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By spreading your investments across [inaudible 00:00:55] sectors with lower correlation to each other you reduce price volatility. And this is key if you want to diversify or truly diversify your portfolio you need to choose sectors that have lower correlation between then. And the reason is that because of the low colouration between industries and sectors you are assured that your holdings will move at very different rates. For example if you have a holdings in the technology information sector and the health care sector and the health care sector tanks. The technology information or the information technology sector can be rising so you’re going to have some kind of a hedge between the two of them. And that is how you reduce risk with a portfolio.

No matter how diversified your portfolio is you can never eliminate the risk of investing in the markets. When investors try to do this it’s when over diversification becomes a problem. The generally accepted way to measure risk by looking at volatility levels through the standard deviation. That is the more sharply a stock or portfolio moves within a period of time the riskier it is. According to the modern portfolio theory you’d come very close to achieving optimal diversity after adding about twenty stocks to your portfolio. Now remember that this is just a theory but twenty stocks in a portfolio is the limit when it comes to over diversification of your portfolio.

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And now I’m going to tell you the problems with the over diversification. The first one is that the benefits of diversification quickly diminish after adding twenty stocks to your portfolio and the reason is that over diversification occurs when the number of individual investments in a portfolio exceed the point where adding an investment asset doesn’t reduce the risk of the portfolio more than the loss of potential returns.

So after twenty stocks in your portfolio the more stocks you add will not reduce the risk but will diminish the potential returns of your entire portfolio. And over diversification guarantees average profits or average performance at best.

A portfolio with too many stock is spread so thin that the investor can only hope to achieve returns consistent with the broader market. This means that if you have a hundred or a hundred and fifty stocks in your portfolio you are spread so thin or you have so many stocks from so many industries and sectors that your returns will be consistent with the broader market. And when that happens only the addition of a superior asset adds value to the portfolio.

Well the goal of this lesson is to teach you that when you are trying to build your portfolio you should really consider only looking at two or three sectors and no more than three to four stocks per sector and go from there.

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