What I learned: Stock diversification

If you load up your investment portfolio with only tech stocks or only pharmaceuticals, for example, your risk level is high because what impacts one type of stock will likely impact all the other similar stocks. This is called independent risk, or idiosyncratic risk, and it’s completely unnecessary. You can virtually eliminate this risk – diversify it away – simply by having a minimum of 30 different types of investments in your portfolio.

A lot of folks who are interested in investing for the future also own a home. Of course a home is a great investment but, unless you’re a millionaire, you’re putting a whole lot of eggs in the same basket (subjecting yourself to idiosyncratic risk). This is especially true if you also own an index fund that is in REITs (Real Estate Investment Trusts) and maybe even own a second home for rental income.

Here’s how to find out how diversified you are. Take your net worth (assets minus your debts) and divide by 30. This is the theoretical maximum you should have in any single investment in order to be properly diversified. If your net worth is, say, $450,000 (including the estimated resale value of your home minus your mortgage balance), then the most you should be holding in real estate is $15,000.
However, if you’re like most Americans, your home is probably at least 40% of your portfolio. Add to that your REITs and that rental property, and you’re way under-diversified. If you don’t own a home, maybe you should just own $15,000 worth of REITs. It is, of course, a personal choice. Just keep this in mind when you consider the riskiness of your investments.