Diversified investing without a stock index
Direct stock investments can be a sufficiently diversified investment if done right. This means it doesn't require a stock index fund to be diversified because economists have demonstrated that the benefits of diversification can be achieved with only a few shares. Holding 20 to 30 stocks provides most of the diversification benefits.
Compared to an index fund, a diversified equity portfolio has the advantage that there are fewer commissions and no counterparty risk. We call it Do-it-yourself indexing.
For diversified investing the following three points need to be considered:
Diversify over time
First, a point that is often forgotten: Share purchases and disposals should always be carried out over longer periods of time. Therefore, never say, "Let's invest now and then we are all done". It is much better if the investing happens over several months and vice versa. So:
That's what safe investing is all about
Because you never know where the ups and downs of the stock market will be.
Mix industries and size classifications
Industries with bright prospects are generally valued higher than industries with poor prospects. Therefore, the good industries rarely provide a higher return than the bad. The focus on a special industry therefore rarely make sense, because the expected returns are not better.
The size classification of a company should not be taken into consideration, because they behave differently depending on the phase of the market. In good times smaller stocks tend to profit more because generally there are fewer concerns to invest in shares. When times get tough, the big players benefit more because shareholders flee to safety. Since you do not know what the future holds, it is recommended to mix the size classifications in your portfolio. For safety reasons, laymen should stick with larger stocks (XL or XXL) because they are generally more stable.
Better diversified than an index
It is often assumed that the best diversified investment is a stock index. But this is not necessarily the case. Often stock indices are only moderately diversified because they are weighted according to market capitalization. Expensive stocks in the index are thus more important than cheaper stocks. In Switzerland, before the credit crunch, the largest stock index, the SMI, was mostly comprised of banking stocks, a half dozen years later it was food and pharmaceutical stocks. At the time when one should have invested in fewer financial stocks, investors were excessively exposed to these stocks when they bought the SMI Index.
Even the mighty Standard & Poor's 500 Index was influenced heavily by only one stock - Apple - so that the returns had to be shown with and without Apple's influence during certain periods. And at the beginning of 2015 even in the MSCI World with 1,600 shares, every 5th share was a financial company stock. But the world does not consume 20% finances, it consumes - strictly speaking - everything else. What is generally meant by the world market, is therefore poorly displayed by the MSCI World. This is even more prevalent in smaller countries indices. In the English FTSE100 Index one mostly buys oil stocks in the DAX, it is the chemical industry and the automakers.
Investors who buy index funds, therefore, don't always get a diversified investment of the overall market but often a particular industry focus, which isn't always known. Better diversification is achieved by holding 20-30 stock from what we call the Do-it-yourself index. And one can define the market based on one's own views without having to rely on third parties who might see the world quite differently.