Diversification is more than just owning different stocks

I spoke with a friend of mine this past weekend, well he’s actually a coworker – but he moved states with the company, so I no longer work with him. One thing led to another and we were talking about how well the company is doing, and that’s when he chimed in about his stake in the company. He has been allocating 90% of his contributions (and the company match) to our company stock. I couldn’t believe my ears. He assured me though, he was diversified. He then proceeded to tell me he had a number of other stocks, and so he was diversified. The problem is, diversification is more than just owning a number of different stocks, it’s allocating your dollars across a number of stocks. Just because you have 10 different stocks doesn’t mean you’re diversified. Let me explain better below:

Poorly diversified portfolio of 10 different holdings ($10,000 investment – assuming all investments carry equal risk):

Stock A: 20 Shares, $500

Stock B: 2000 Shares, $1000

Stock C: 1500 Shares, $500

Stock D: 250 Shares, $100

Stock E: 1200 Shares, $400

Stock F: 300 Shares, $900

Stock G: 500 Shares, $1100

Stock H: 20 Shares, $500

Stock I: 15 Shares, $500

Stock J: 2500 Shares, $4500

Why is this bad? You’ve got $4500 in one company, or 45% of your investment dollars in one place. Your portfolio is too heavily dependent on one company. You should have no more than10% of your portfolio in any given investment or industry or company, etc.

Below is an example of a properly diversified portfolio ($10,000 investment – assuming all investments carry equal risk).

Stock A: 20 Shares, $1000

Stock B: 200 Shares, $1000

Stock C: 1500 Shares, $1000

Stock D: 250 Shares, $1000

Stock E: 1200 Shares, $1000

Stock F: 300 Shares, $1000

Stock G: 500 Shares, $1000

Stock H: 20 Shares, $1000

Stock I: 15 Shares, $1000

Stock J: 2500 Shares, $1000

Now, this is simplified, but the idea is to spread your risk, so if one investment is doing bad, chances are another will offset that down stock.