When evaluating investment opportunities, diversification can be an essential part to managing investment goals. Diversifying your investment portfolio is considered a way to help balance the inherently risky nature of investments. How many companies should an investor have in their portfolio to be considered diversified?
The Portfolio Magic Number
The bottom line is that there is no magic number of investment opportunities that should be in an investor’s portfolio. A diversified portfolio is subjective and depends on many factors including risk tolerance and investing goals. In an ideal world, a prudent investor would diversify their portfolio in a way that helps mitigate investment risks while working to achieve investment goals. There are a few different ways to diversify your investment portfolio to help provide direction when attempting to achieve this goal.
The basic goal of portfolio diversification is to invest in opportunities that have uncorrelated risks and potential returns. By investing in different types of opportunities with these uncorrelated factors, investors may not lose as much portfolio value if one specific industry takes a hit. If an investor’s portfolio is filled with similar companies and similar industries, when one industry underperforms, the entire portfolio’s value could decrease. Alternatively, if an investor invests in opportunities across multiple industries, if one industry does not perform as well, the remaining industries in the portfolio may not perform in the same way.
Many investors choose to diversify through characteristics of businesses. Some diversification characteristics include:
Diversification by industry helps disperse investments across different technologies, types of products, and areas. Whether fintech, SaaS, manufacturing, or other industry, spreading investments across industries can help mitigate risk.
Some investors prefer to diversify with company stage. Early-stage companies are generally considered to be raising pre-seed, seed, Series A, or Series B rounds. Later-stage companies could be raising Series C and beyond rounds or company shares could be traded on the secondary market. Diversifying through company stage can space out the time horizons for exit opportunities.
Every investment has a time horizon, or the time period where one expects to hold the investment to help achieve a specific goal. For example, an anticipated time horizon for an early-stage exit could be seven to ten years. For late-stage companies, the exit time horizon could be five years. Diversifying through potential exit time horizons can help space out when funds across a portfolio are needed for investment goals.
Diversifying through asset class (like stocks, bonds, alternatives, or commodities) can help mitigate risk across different economic situations. In a strong economic environment, stocks tend to perform better than some other asset classes. During economic downturns, bonds could be a better choice depending on your situation. Different asset classes can provide further diversification to help mitigate risk.
Another diversification characteristic is geography, or the country in which the company operates. Diversifying across international borders can further spread out investments across opportunities and add a layer of diversification. A combination of diversification characteristics can help provide a mix of diversification characteristics to mitigate potential risk.
Portfolio is Diversified – Now What?
Investment portfolios are not a “set and forget” kind of thing. Investors should regularly check in on their portfolio and see if adjustments may be required, change allocations if needed, and ensure that their current portfolio mix is performing up to their specific investment goals. There is no portfolio magic number that tells an investor how many companies they should be investing in. Investors have the ability and freedom to choose where their money is invested, and can make informed decisions as to what they invest in. Portfolio diversification may add a layer to an investor’s portfolio that can help mitigate the inherently risky nature of investments.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.