How Diverse Should My Investments Be?

Diversity is another "everyone knows" fact about share trading.

Diversity Of Investments Are Limited By Funds Available

In this site I tend to talk about £5K pots, however this shouldn't be seen as some form of "£5K good, £2K bad, £20K bad", especially if you are starting out with a few thousand pounds.

I simply needed a starting point, a value that gives some sort of an idea of what is under discussion.

A £1K pot is probably the minimum viable as any less will see dealing fees and stamp duty eat too heavily into the profits.

A £10K pot will probably seem too large for people considering trading for the first time.

A £20K pot is probably optimal, the returns are meaningful in money terms and not too large as being a real problem to trade.

Hence the £5K pot, a happy medium.

Balancing Risk, Growth And Feeling That You Are Getting Somewhere

There is no ideal ratio for number of pots:pot size, you need to find a balance between how many pots you want to have for diversity's sake against the cost of dealing and the difficulty of finding suitable companies along with some emotional factors.

As a simple rule less than five is really bad as you are too exposed to one bad decision and more that 15-20 is too many to manage and you have maximised the benefits of diversity.

More Pots
  • Reduce losses from a bad decision.

  • Mean that you may run out of "best choices" and have to buy less attractive shares.

  • Average (mean) smaller absolute profit per trade possibly tempting you into more risky options.

  • Mean more frequent trades so you will always feel that you are achieving something as individual profits are small amounts.

Fewer Pots
  • A real danger of losing a large portion of your capital from a single bad decision.

  • Maximize profits from good decisions.

  • Mean that you can pick just the best opportunities.

  • Mean bigger absolute profits.

  • May result in less frequent trades, such as none during the last three months, tempting you to trade just because you want to do something.

  • May result in larger dealing fees as you may need to make multiple buys and sells to use the whole pot value.
Originally I tried to keep all pots roughly the same size, when a pot grew to about twice the average pot size it was split into two.

I now try to keep all pots roughly the same size, when a pot grows to 120%-130% the average pot size I take this difference and add it to some or all the pots to keep the differences as small as possible.

The second approach reduces the impact of a mistake with a pot just about to be split.

I also keep one or two small pots, these are reserved for those shares that look promising but have low trade volumes.

Despite suggesting that personal preference is important, I would be looking for at least 5 pots from day one.

This allows you to mess up one pot, lose 50% of that pot and still only be down by 10% of your total investment.

I appreciate that if you are starting with £5K and creating 5 pots then each pot will be a very small £1K. So you will need the will power to stay motivated by £50 - £100 profits.

Losing a lot of your money by having just two pots and choosing badly will de-motivate you even more.

No matter how many pots you have, you will probably get tempted to speed up your portfolio growth by buying "that share which is obviously going to double its value in the next few months" using all of your pots.

Resist this urge!

By the time you get to 15-20 pots actual diversity is less than apparent diversity as you may be invested in construction, banks and retail but you also start to see the interaction.

Oversimplified, XZY Construction shuts down, staff are laid off so they default on their bank loans and buy less causing some shops to close which affects the landlords.

The 2% Rule - Minimize Your Exposure

You will probably come across many articles that propose that no more than 2% of your total investment should be in a single share. The idea is that even a total wipe-out of that share would be unfortunate but only slightly inconvenient.

At first glance this is very sensible advice, but as soon as you think about it and then try and implement it you will know that very few private investors would ever say and practice this.

This advice means creating 50 pots, this is problematic for three reasons.

Although there are over 2,000 companies traded on the London Stock Exchange, The FTSE All Shares Index which covers most companies that are safe for a beginner has about 620 companies in it. Even allowing that a company is potentially a suitable investment, the reality is that most of these 620 companies will have share prices that currently make them unsuitable for purchase.

The second problem is size, assuming that you are going to be cautious and invest £5K, this means that each investment would be £100.

Allowing for dealing fees of £10 to buy and £10 to sell, a 10% growth in the share price would result in 10.5% loss, mustn't forget about stamp duty!

Unless you are committed to simply putting your money into the shares and doing nothing for the next 15 years managing a portfolio of 50 pots will consume more time than a part time trader will be prepared to spend.