The 5% Diversification Rule for Smarter Investing

chalkboard drawing of three people putting eggs into three baskets to signify diversification

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When it comes to investing, almost everyone wants to snag the next big winner. Stories abound of investors getting in early and benefiting from explosive growth, sometimes building their fortunes on a single win alone. However, for every story of triumph, there are dozens, if not hundreds, of cautionary tales of investors who placed big bets only to see them crumble.

"While the upside of concentrated positions can be enticing, many of the most successful investors believe the risk is too high," says Erin Scannell, a private wealth adviser at Ameriprise Financial.

This is where one of the most powerful, yet overlooked, investing strategies comes into play: the 5% Diversification Rule.

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It's a simple principle that says the highest probability of long-term success in investing isn't from chasing the next hot stock; it's from building a robust, resilient portfolio that can weather any storm and still capture growth.

What is the 5% Diversification Rule?

The 5% Diversification Rule states that no single position should make up more than 5% of your portfolio's total value.

So, if your portfolio is $100,000, no investment should be worth more than $5,000. The reasoning behind this rule is that it prevents any single holding from tanking your entire portfolio.

To illustrate this, Scannell gives an example of two $1 million portfolios. Portfolio A is concentrated with 20% allocated to each of five individual investments. Portfolio B is broadly diversified across the entire stock market.

"Assuming a bull market year where the broad market rises by 15%, Portfolio B could grow to approximately $1.15 million," Scannell says. "In contrast, if four of the holdings in Portfolio A outperform and rise by 20%, but one investment loses all its value, the portfolio's overall value could decline to around $960,000."

If your portfolio were even more concentrated in that one bad egg, the losses could be even steeper.

How to use the 5% Diversification Rule

To apply the 5% Diversification Rule in your own portfolio, simply review your holdings and trim any position that accounts for more than 5% of your total portfolio value.

You can do this by selling enough of your outsize investments to bring their weighting back to 5% of your portfolio, and use the proceeds to buy enough shares of any underweight positions to bring them closer to the 5% mark.

It should be noted that no two investors are exactly alike. Some may find even a 5% allocation too unnerving, in which case a 3% or even 2% rule might be more appropriate, says Andrew Crowell, financial adviser and vice chairman of wealth management at D.A. Davidson.

He also points out that many exchange-traded funds (ETFs) and mutual funds may not be equal-weighted, so even if the ETF itself is a 5% weighting in a portfolio, it may be carrying more risk than you realize.

Caveats to the 5% Diversification Rule

While the 5% Diversification Rule can be applied to all asset classes and investment types —from stocks and bonds to funds —it's most important when applied to equities. Some would even argue the rule is unnecessary for fund investors.

"A position in an ETF like the SPDR S&P 500 ETF (SPY) and the Invesco QQQ Trust (QQQ), or even thematic vehicles such as the Health Care Select Sector SPDR Fund (XLV) or the VanEck Semiconductor ETF (SMH), represents diversified exposure across dozens or hundreds of underlying holdings," says Elliot Dornbusch, CEO and chief investment officer at CV Advisors. "Labeling such allocations as 'single positions' mischaracterizes their risk contribution."

A 10% allocation to SPY carries far less idiosyncratic risk than a 3% stake in a single small-cap stock, he says. Similarly, a 15% allocation to U.S. Treasuries would add stability, not volatility.

When not to use the 5% Diversification Rule

For many investors, a 5% diversification threshold is a smart way to ensure their portfolio is adequately diversified and limits volatility. However, there are times when you may choose to deviate.

"Successful investing often rewards conviction and patience," Dornbusch says. "Diversification protects capital; concentration builds it."

Many investments will grow into outsize positions over time, he says. Forcing a sale simply because your position has breached the 5% threshold would interrupt its compounding and growth potential. For this reason, he argues that "a disciplined review process should govern size, not a static rule."

Scannell also deviates from the 5% rule at times, but only after "significant research into the fundamental health of the business." And even then, he wouldn't recommend going above a 10% allocation.

The flexible 5% Diversification Rule

The most important takeaway for investors is that diversification is important, and using a guideline such as the 5% Diversification Rule can help keep you on track in meeting your financial goals. However, you don't have to be rigid in your adherence to it.

Crowell recommends applying a tolerance band of 2.5% to 3% to the rule. "Rather than trimming 1% just because an investment has appreciated to 6% within the portfolio, waiting until it is 7.5% or even 8% to 'true-up' to the 5% target might make more sense," he says. Additionally, this more flexible system may result in lower trading costs from less frequent rebalancing.

You could also apply different band sizes to various asset classes. For example, "a 10% to 15% allocation to Treasuries, a 7% position in a high-conviction equity, or even a 20% exposure to a diversified ETF can all be appropriate — provided they fit within the portfolio's overall risk architecture," Dornbusch says.

If you do decide to place more concentrated bets, the key is control. Maintain liquidity buffers, monitor correlations and actively manage downside risk while allowing for the upside to compound, Dornbusch advises.

Coryanne Hicks is an investing and personal finance journalist specializing in women and millennial investors. Previously, she was a fully licensed financial professional at Fidelity Investments where she helped clients make more informed financial decisions every day. She has ghostwritten financial guidebooks for industry professionals and even a personal memoir. She is passionate about improving financial literacy and believes a little education can go a long way. You can connect with her on Twitter, Instagram or her website, CoryanneHicks.com.