New York (CNN Business)Say you have $100,000 to invest. What's the better diversification strategy? Owing 20 stocks valued at roughly $5,000 each, or five stocks valued at $20,000 each?
First off, congratulations on having $100,000 to invest! But this is a great question even if you have just $10,000 or $1,000. Most people don't have the time to research hundreds of companies.
It's tempting to look at how well the big FAANG tech companies — Facebook (, )Amazon (, )Apple (, )Netflix ( and )Google ( owner Alphabet — have done over the past few years and decide that you should just invest with these market leaders and call it a day. )
But that's a dangerous strategy. Sure, a highly concentrated portfolio with just a handful of names can do really well when times are good.
However, if things turn south, that same group of stocks could do much worse than the overall market. Just look at what happened to internet stocks in 2000 or banks in 2008.
"Being very concentrated is a big risk," said Luca Paolini, chief strategist at Pictet Asset Management. "Unless you have very strong views about a specific group of stocks, it's better to be diversified."
Paolini said true diversification doesn't mean invest only in US stocks, either. Even if you own something like an S&P 500 ETF (, you still wind up with a lot of exposure to the giant tech firms that dominate that index. )
That's why Paolini argues investors should also have exposure to companies around the world, as well as bonds, which can help cushion the blow when stocks aren't doing well.
Brad McMillan, chief investment officer of Commonwealth Financial Network, agrees. He said true diversification means spreading your money widely.
"For the average person, you're much better off not making a focused bet," he said, adding that ETFs pegged to an index like the Wilshire 5000 ( really give investors maximum diversification. )
That doesn't mean that you can't have a portfolio with just a small number of stocks. But if you choose to adopt that strategy, it will work best if you are truly an expert in a certain business.
Terry Sandven, chief equity strategist at US Bank Wealth Management, said that a concentrated portfolio could make sense — but only if you are willing to withstand market volatility, and if you have experience with and an understanding of a specific industry. That's not the case for most investors.
"The most prudent strategy is to own more stocks than having concentrated positions. With 20 stocks, you could own companies in all the major sectors," Sandven said.
McMillan added that investors also shouldn't be afraid to keep some money on the sidelines.
"Investors underappreciate the role of cash. People think you always need to have your money in the market," McMillan said. "But having cash gives you the opportunity to buy when the market goes down and lets you sleep at night."
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