2. Insufficient Diversification. Another common investor mistake is to have an under diversified portfolio. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. And generally speaking, the more diversified portfolios performed better: the most diversified investor group in the study earned more than 2% a year higher returns than the least diversified group.
Behavioral finance concepts behind this mistake include investors’ tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions and to opt for familiar home-market stock names that can be recalled easily.
Market Realist – The graph above shows how a diversified portfolio—comprising 12% S&P 500 Large Cap Index (SPY), 12% S&P 400 Mid Cap Index (MDY), 12% S&P 600 Small Cap Index (IWM), 12% MSCI EAFE Index (International) (EFA), 12% Emerging Markets Index (EEM), 13.3% Barclays Credit Index, 13.3% Barclays US Treasury Index (TLT), and 13.3% Barclays Capital US High Yield Index (HYG)—gives higher returns than an under-diversified portfolio comprising 60% S&P 500 Large Cap Index and 40% Barclays Credit Index.
Diversification doesn’t simply mean increasing the number of stocks in your portfolio. It means increasing your exposure to different asset classes so that your portfolio can withstand changes in the economic climate effectively.
Read on to the next part of this series to learn why inefficient trading can cause you losses.