Often people refrain from investing in the stock market because they think they do not have enough money to do so. In this article, we will take a closer look whether this holds true.
"Don't put all your eggs in one basket."
As most people tend to be risk averse, diversification plays a big role when investing in the stock market. Diversification limits the impact of bad apples in your portfolio (but also the upside of stocks that do exceptionally well). Let us look at a numeric example.
The impact of diversification
Investor Jan has a stock portfolio containing 20 different businesses that account for 5 % each. One of them, the German payment firm Wirecard, has to file for insolvency after a severe case of fraud. Consequently, the stock drops from 100 to 1 euro per share. Jan has lost close to 100 % of his investment. Luckily, Jan diversified and the impact of one bad apple on the entire portfolio is relatively minor. While Wirecard's stock lost almost 100 %, Jan's portfolio only lost 5 %. Therefore, a diversification strategy is widely used by retail investors around the globe.
The costs of building your own stock portfolio
Buying stocks was traditionally costly for individual investors. If Jan's transaction fees were say 30 euros, it would not make sense for him to buy stocks for 100 euros each. Transaction costs (buying + selling) alone would cost him 60 % of his initial investment. As a consequence, people could only create a well-diversified portfolio if they had sufficient funds available to them. A young adult with for example 1'000 euros in savings would have had a hard time to diversify his portfolio without having the fees eating up a lot of his/her performance.
Luckily, there are many low-cost brokers around nowadays offering e.g. flat fees of 1 euro per trade. Suddenly, instead of 60 % Jan only pays 2 % fees (buying + selling) for his 100 euros investment, which is much more reasonable. Typically, a portfolio is considered diversified somewhere between 10-30 positions. Some investors prefers less, some prefer more. Nowadays, investors can comfortably build a well-diversified portfolio with about 2'000 euros. As a rule of thumb, every transaction should not cost more than 1 % of the transaction volume.
What do the experts say?
Some famous investors even argue that there is no need for broad diversification. Take Charlie Munger for example, Warren Buffett's long-standing partner at Berkshire Hathaway:
"My own inquiries on that subject were just to assume that I could find a few things, say three, each which had a substantial statistical expectancy of outperforming averages without creating catastrophe. If I could find three of those, what were the chances my pending record wouldn't be pretty damn good. I just sort of worked that out by iteration. That was my academic study - high school algebra and common sense."
Warren Buffett himself has made some comments regarding diversification:
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
“Wide diversification is only required when investors do not understand what they are doing.”
Concentrated portfolios may perform a lot better but also have a higher downside should your investment thesis turn out to be wrong. Broadly diversified portfolios limit your downside but also your upside potential. Whether you go with Buffett and Munger - a concentrated portfolio - or prefer to have a very diversified approach is a question every investor has to answer for him/herself.
To sum things up
Building a decent portfolio is possible for almost everyone. You no longer need vast amounts of money to get started. Speaking of started: No matter how concentrated or diversified your portfolio, the most important thing is to get started.