Saturday, March 3, 2012

Diversification and Commissions

Many stock pundits and advisors strongly recommend diversification, that is, holding more than one stock to reduce risk.  This is the idea that it is a good idea to put all your eggs in one basket.  More on the concept later, but I wanted to address the impact of diversification on commissions here.

Different experts (and I will use the term loosely) recommend different numbers of stocks to be diversified, but for our example we will use five.  Assume a starting portfolio of $10,000, a not insignificant sum for most people.  In order to purchase five stocks at $8 per buy, the investor is down $40 from the get-go.  Of course, in order to unwind the positions, that is, sell the stocks, he will have to pay another $40.  Diversification has cost him $80, or 0.8%,   He could have put all $10,000 in one stock and been better off even if the stock went down in value by one half of one percent. 

Whatever the benefits of diversification, and there is some debate on the value, it does create a financial hole that the investor has to dig out of.  It may be better to put all of your eggs in one basket if the cost of buying many baskets is going to cause you to go broke anyway.       

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