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Diversify to Enhance Total Return and Limit Volatility

Author and economist Peter L. Bernstein once wrote, "Diversification is the only rational deployment of our ignorance." Which begs the question: What exactly is the optimal level of diversification to dilute our ignorance but not our performance?

In 2002, Morningstar analyzed the returns of large company stock mutual funds. They segmented the funds into six categories according to the number of stocks owned in each portfolio. The most concentrated portfolios held 10 to 20 stocks, while the least concentrated held more than 100 stocks. Results were measured over 10 years. The best-performing category? Portfolios holding 10 to 20 stocks. My experience proves what the research suggests: More is not necessarily better. When we own a few great companies across broad economic sectors, we will generate excellent returns over time.

This column has advocated owning shares in companies of industry leaders. Since economic sectors are made up of numerous industries, it is important for us to understand if we have too much or too little exposure to a particular sector to ensure proper, real diversification in our portfolio. To do so, I go to Fidelity Investments' website, fidelity.com, then click on "research" and click on "stocks."

There I can review the underlying industries that comprise each sector, industry and sector performance over various time periods, the relative importance of the sector in the overall stock market and a comparison of each sector's expected performance during various phases of the business cycle. This information provides me with the tools I need to make sure I am not overdeploying my ignorance and truncating my total return.

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