As you start to research the stock market, one of the first lessons you’ll learn is that diversification is an important part of investing. You’re told that without proper diversification, your portfolio will be susceptible to significant losses should one of the stocks in your portfolio take a dive.
But what exactly is proper diversification? Should you own three stocks, five stocks, or 500 stocks?
With no real line drawn in the sand, beginner investors are often left to decide what they believe the best way to go about diversification is. That can be dangerous. An underdiversified investment portfolio could see significant short-term losses that can be hard to recover from. A portfolio with too many stocks makes it impossible to keep tabs on each and every investment you’ve made.
So, where’s the middle ground?
The answer is the 5% rule — a rule of thumb that provides guardrails to help ensure that your portfolio doesn’t lack diversification.
What Is the 5% Rule?
The 5% rule is a tool that should be part of just about every investing strategy. The rule suggests that no more than 5% of your total investing dollars should be invested in any single asset, and no more than 5% of your total investing dollars should be invested in any group of high-risk assets.
For example, let’s say you have a $10,000 balance in your investment portfolio and you’re looking at Stock A, Stock B, and Stock C. They are all relatively low-risk investment options. You’re confident that Stock A will generate an incredibly strong return. You’re pretty sure that the return on Stock B will be compelling as well, and while you’re unsure about Stock C, you want some exposure to the stock.
The 5% rule suggests that you aren’t supposed to invest more than 5% of your investment portfolio in any of these stocks, but it doesn’t stipulate the exact amount you should invest. That’s up to your opinion of the stocks. The 5% rule works as a limit, not a mandate.
So, in this example, because you are confident that Stock A will generate strong returns, you might invest your maximum of 5% of your investment dollars — $500 — into the stock. Stock B seems promising, but there are some questions, so you might choose to invest a little less in this one — maybe 2.5% of your portfolio, or $250. And while you’re completely unsure about Stock C, you want exposure to it because it could see strong gains. In this case, you may consider investing 1% of your investment portfolio, or $100, in Stock C.
You might also be looking at a group of three more high-risk stocks; call them Stock D, Stock E, and Stock F. You believe Stocks D and E will see significant gains, but due to their status as penny stocks, you know the risk is high. Stock F seems promising too, but the investment hinges on a deal that you’re not sure will come to fruition.
In this case, the 5% rule stipulates that you only put 5% of your total investing dollars — or $500 — across this entire group of three high-risk stocks. Because you strongly believe in Stocks D and E, you might decide to invest 2% — or $200 — into each, leaving you with $100 to invest in the highly speculative bet on Stock F.
By diversifying your portfolio based on the 5% rule, you’ll protect yourself from significant losses should any of these single investments experience significant declines.
Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares.
How the 5% Rule Protects Your Investment Portfolio
What’s the point in all of this? If you’re sure a stock is going to fly in the near future, why not just throw 100% of your investing dollars at it and wait for the ride that’s ahead? Is a diversified portfolio really a good thing?
The fact of the matter is that no investment strategy is 100% accurate and no investor will make successful investments 100% of the time. As such, if you risk 100% of your investing dollars on a single investment and that investment goes wrong, well, you’re back to square one, licking your wounds after experiencing significant losses.
The 5% rule gives you a way to invest toward your financial goals without risking significant losses in the process. After all, as long as you’re following the 5% rule, even if one of your investments falls to zero you won’t go bust. Sure, a decline like that will still hurt, but it’s the kind of pain that can be shaken off before you try again.
How to Adjust the 5% Rule to Your Risk Tolerance
The 5% rule is a general rule of thumb and can be adjusted based on your risk tolerance. However, if you are a newcomer to investing, it’s best not to adjust anything and follow the rule for at least a few months to get the feel for stock investing in general.
After all, you don’t want to risk too much of your nest egg before really understanding what investing is.
As you become more comfortable in the stock market, you may decide that the 5% rule doesn’t meet up with your financial goals. Maybe you want more exposure to volatility to take advantage of wide swings in value of some assets, or maybe your idea of successful investing is a low-risk approach that the 5% rule doesn’t satisfy.
When adjusting the 5% rule, it is best to adjust it in 2.5% increments. For example, if you would like to accept more risk in return for a larger level of reward, instead of the 5% limit you may move to 7.5%. After a few months, if your portfolio looks to be enjoying a bull market you might adjust the rule to 10% — but know that this is riskier still.
On the other hand, if you’re a risk-averse investor and the idea of losing 5% of your investing dollars in a single investment scares you, you might be inclined to reduce the rule to a 2.5% limit, allocating a maximum of 2.5% of your investing dollars toward any single investment or any group of high-risk investments.
Keep in mind that as you adjust the rule, you’re taking part in a give-and-take proposition:
- Adjusting the Rule Up. As you adjust the rule up, your primary goal is to take advantage of the upward movement in valuations in a smaller group of assets. However, doing so exposes you to higher levels of risk. If 10% of your investment portfolio is invested in a single stock and that stock price falls to zero, you’ve lost 10% of your nest egg in a single move.
- Adjusting the Rule Down. Adjusting the rule down will reduce your risk of significant losses on a single investment. However, it also reduces your exposure to your highest performing investments, limiting your return potential. Furthermore, as you add more stocks into your portfolio, you’ll need to devote more of your time to research and maintenance to ensure that your portfolio doesn’t get away from you.
Does the 5% Rule Apply to ETFs, Index Funds, and Mutual Funds?
If you’re investing in exchange traded funds (ETFs), index funds, or mutual funds, your investments are already heavily diversified. Therefore, the 5% rule becomes moot. Although some investment-grade funds will have more than 5% of their assets invested in a single stock, the vast majority of these funds are heavily diversified to provide exposure to an entire index, sector, or class of securities. By holding a diversified fund, you accomplish the same dilution of the risk associated with holding too much of any single stock.
Mixing Single Stock Investments With ETFs While Employing the 5% Rule
Many beginner investors start by investing in ETFs and other investment-grade funds and venture off into picking their own investments later. However, as a beginner — or even an expert who’s pressed for time — you may not have the time to research single stocks to complete a diversified investment portfolio.
It’s OK to invest in a few stocks, following the 5% rule while making these investments, and fill the gaps in your portfolio with ETFs and other investment grade funds. While your fund investments will not follow the 5% rule, all of your single-stock investments should.
Pro tip: If you’re going to add new investments to your portfolio, make sure you choose the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Rebalance Your Portfolio on at Least a Quarterly Basis
Setting up a balanced investment portfolio is just the first step. Rebalancing your portfolio is just as important. As the assets within your portfolio rise and fall in value, it becomes necessary to rebalance your portfolio quarterly to ensure that you’re not over- or underexposed to any single investment.
Rebalancing your portfolio is a simple process. All you need to do is review your portfolio to make sure that no single stock investment has grown to take up more than 5% of your portfolio. When you find some that have, simply take profits on those investments by selling enough shares to move your position back to the 5% mark.
It’s also important to look at the stocks whose allocations have fallen well below 5%. Based on their standing within your portfolio, it’s clear that these stocks are either losing money or — if they’re gaining but still shrinking as a percentage — they’re underperforming compared to the rest of your portfolio.
Do a little research to get an understanding of why these stocks are underperforming and whether it’s time to sell them and use the funds to invest in other stocks that are likely winners.
While it’s advisable to rebalance your portfolio on a quarterly basis, some of the most successful investors are the most attentive. Monthly rebalancing may be cumbersome, but it could lead to a substantial difference in your long-term returns.
Is Diversification Right for You?
Diversification is a hot topic of debate. Although the vast majority of experts suggest maintaining a well-diversified portfolio, others — including like famed investing mogul Warren Buffett — don’t like the idea. In fact, Buffett was once quoted as saying, “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.”
So, if diversification isn’t good enough for Warren Buffett, is it really an important investment strategy for you? This quote has been taken out of context time and time again, used to suggest that the average investor is best off choosing two or three stocks and sticking to them.
That notion leaves the entire second sentence out of the quote. “It makes very little sense for those who know what they’re doing.” That’s an important part of the statement. Buffett is referring to financial experts, certainly not newcomers or even average and experienced investors. In fact, Buffett suggests using low-cost ETFs as investment vehicles to suit the financial needs of the vast majority of investors. ETFs are some of the most highly diversified investment vehicles in the world.
So, even Warren Buffett sees diversification as an important form of protection for the majority of investors.
The 5% rule is an investing strategy that has proven effective time and time again. By taking advantage of it, you’ll have the ability to protect your portfolio from significant losses in the event of an unexpected downturn in one or more of your investments.
Keep in mind that if you don’t have the time it takes to track all of the investments to create a highly diversified portfolio, it’s perfectly fine to use ETFs and other investment-grade funds to fill the gaps.
Even when following the 5% rule, it’s important to do your research before making any investment. Always remember, educated investing equates to successful investing.