When evaluating a company's financial performance, investors and analysts often use profitability ratios to assess how efficiently a company is generating returns from its resources. Three widely used metrics are Return on Equity (ROE), Return on Assets (ROA), and Return on Investment (ROI). Each of these ratios offers insight into different aspects of a company’s profitability, helping investors understand how effectively a company is using its equity, assets, and investments.
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Portfolio Diversification
Portfolio diversification is a fundamental concept familiar to many investors. However, revisiting this strategy with a fresh perspective can yield valuable insights. Building on the ideas from our previous discussion on the Circle of Competence, let's delve into how diversification relates to an investor's unique expertise and decision-making process.
The Essence of Diversification:
Diversification involves spreading investments across various companies, industries, and countries. Yet, it's crucial to recognize that a highly diversified portfolio often translates to moderate performance, raising a point to consider: might it be simpler and more efficient to invest in an Exchange-Traded Fund (ETF)? A broad portfolio can be overwhelming to manage, with the constant influx of news and updates making informed decision-making more challenging.
Customizing Your Portfolio's Breadth:
There's no one-size-fits-all answer to the ideal number of stocks in a portfolio, as it greatly depends on individual circumstances and time availability. Let's ponder a scenario for reflection: imagine discovering an undervalued company that fits snugly within your Circle of Competence, making it logical to invest a substantial amount. However, if you're adhering to a rule like capping investments in a single company at 5% of your portfolio, you could be missing out on potential gains by forcing yourself to seek other companies where you might not anticipate similar returns or lack sufficient information.
A Balanced Approach to Diversification:
This isn't to suggest putting all your eggs in one basket, but rather to think critically about your investment choices. The "right" number of stocks doesn't exist universally; it's about recognizing when a company presents a high probability of exceeding your portfolio's expected performance. When such an opportunity arises, it's worth considering capitalizing on it appropriately.
Conclusion:
In summary, while diversification is a protective strategy, over-diversification might limit potential returns. Balancing your portfolio to match your Circle of Competence and being open to allocating more to high-conviction investments can be a wise approach. Always measure the risks and make investment decisions that align with your knowledge, time, and resources.
The article was written by Michal.
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