The benefits of diversification

When purchasing an individual stock, investors will always be exposed to a certain amount of company-specific risk. This is the risk of an unforeseen future occurrence adversely affecting the company’s performance, and hence its investment returns. An example of company-specific risk would be a strike by the company’s employees. If you were to add a few more stocks to your equity portfolio, the risk of not generating the expected returns on your entire portfolio due to company-specific risk of one individual holding would become much smaller. This strategy is referred to as diversification, and is one of the most important principles of portfolio management.

Diversification simply involves holding a number of unrelated securities in your portfolio. The more securities you hold, the less impact any one under performing stock will have on the performance of your entire portfolio. This is because any individual stock makes up only a fraction of your portfolio; therefore only a fraction of your portfolio is ever exposed to one stock’s company-specific risk. Also, another stock in your portfolio may produce better-than-expected returns, offsetting a poor performer.

A little ersification goes a long way. Studies suggest that as few as eight to twelve carefully selected stocks can significantly reduce the company-specific risk in your portfolio. However, holding more than fifteen will not reduce this risk much further (see the accompanying chart). In fact, trying to stay up to date on more than fifteen stocks can be a difficult task and may even adversely affect the overall performance of your portfolio.

To achieve optimal diversification in your equity portfolio, ensure that you hold several different stocks across several different industry sectors. If this is impractical due to the limited size of your portfolio, a well-managed equity mutual fund may be an attractive alternative. Another excellent alternative is Merrill Lynch’s Blue Chip WealthBuilder™ Equity Portfolio, which allows investors to purchase pre-selected package of high-quality Canadian stocks at a flat commission rate. This portfolio is continuously monitored by a committee of investment professionals at Merrill Lynch, who will make buy and sell recommendations on stocks in the portfolio as warranted.

Adequate diversification can significantly reduce the risk associated with investing in individual stocks, and can provide a greater chance of earning the desired long-term rate of return.

For more information on diversication or the WealthBuilder portfolio, please contact your Merrill Lynch Financial Advisor.

The information contained herein was obtained from sources believed to be reliable, however, the accuracy is not guaranteed.

Financial Tips courtesy of Merrill Lynch Canada Inc.