If you're an investor, you've probably heard about the benefits of diversification. But how do you go about diversifying?
Many people think diversification is just a "numbers game.'' They think that the more stocks they own, the better diversified they will be. However, that's not always the case.
· Asset class - As we've seen, you can diversify your stocks in several different ways. But you may also want to diversify your portfolio beyond stocks by investing in a variety of financial assets, including bonds, Certificates of Deposit, money market accounts and government securities. Again, your individual situation - your risk tolerance, goals and time horizon - should determine your overall asset allocation. But it's probably a smart move to have at least some exposure to the full spectrum of investments.
Generally speaking, of course, it is better to own two stocks than one, and it's even better to own four stocks than two. But you can't really ensure diversification by adding more and more stocks. Instead, you need to add stocks that differ from each other - in many different ways. Why? Because the greater the similarity among your stocks, the riskier your portfolio. Similar companies often face similar economic and market risks - and the stock price of these companies often move in the same direction. And if that direction isn't "up,'' it's not good news for investors who only own those types of stocks. That's why you can't just add more stocks to your holdings and expect to achieve instant diversification. Instead, look to diversify your portfolio by considering the following factors:
· Industry sector - Stocks are categorized in a wide range of industry "sectors,'' such as energy, financial services, utilities, health care, technology, telecommunications, basic materials and consumer goods. To diversify the equity side of your portfolio, try to find high-quality stocks from a variety of sectors.
· Company size - Investors often describe a company's size in terms of its "market capitalization'' - its stock price multiplied by the number of outstanding shares. Companies range from "micro-caps'' - with capitalization of less than $200 million - to "large-caps'' - with capitalization of $5 billion or more. At any given time, those companies with one market capitalization size may perform differently than companies of a different capitalization. That's why you may want to look for good companies from several different capitalization levels.
· Investment style - Some stocks are classified as "growth'' stocks - that is, their primary objective is long-term capital growth. ''Income'' stocks, on the other hand, may provide current income, in the form of dividends, in place of significant capital appreciation. And other stocks offer a combination of growth and income. Your individual preferences, risk tolerance and long-term goals should determine the relative percentage of these stocks in your portfolio, but, for the sake of diversification, it may be a good idea to have at least some representation from all these categories.
Clearly, it will take patience and discipline on your part to truly diversify your investment portfolio. But it's worth the effort. Once you've fully diversified your holdings, you'll have greatly reduced the risk that comes from owning a small number of similar investment vehicles. At the same time, by investing in a wide array of securities, you'll give yourself more opportunities for success.
So, take a close look at your investments. If they all resemble each other, then it may be time to bring in some fresh new "faces.''