Diversification

The more narrowly focused your investment portfolio, the more vulnerable it is to a variety of risks.

For example, if you own just one stock, and the price of that stock drops in value, the value of your portfolio will shrink. Similarly, if the industry the stock is part of goes out of favor with investors — as most industries do from time to time — the value of your whole portfolio will suffer as a result.

But if you own several stocks in different industries or in companies operating in different countries, it’s not likely that they will all drop in value at the same rate and at the same time.

Making a variety of investments to reduce the risks of investing is called diversification. Using this strategy, you carefully select different types of investments to balance your risk. That way, if some investments go down in value, others may go up. And, if you diversify wisely, you may be able to protect your portfolio without giving up the level of return you are seeking on your investments.

Time worth spending

It takes time to diversify a portfolio. That’s one reason many people start investing by buying mutual funds. Since all funds own a number of different investments, and many stock funds own shares of 100 or more different companies, they have diversification built in.

It also takes a certain amount of commitment to diversify and stay diversified. That’s because each time you’re ready to make a new investment, it’s important to identify the investment category that you want to add to your portfolio, and then decide on a specific investment in that category.

For example, suppose you own shares in a mutual fund with a portfolio of blue-chip stocks — the stocks of well-known companies with a history of strong performance. You’re planning to continue buying new shares in the fund, but you also want to diversify. So what kind of investment should you make next? Depending on your financial goals and your tolerance for risk, you may decide on a small-company fund, a mid-sized company fund, or an aggressive growth fund, which invests in companies the manager thinks have the potential to gain value over the long term. Any of these funds will help diversify your portfolio, though their performance isn’t guaranteed.

On the other hand, choosing a large-company fund may not help provide the diversification you seek. That’s because the fund, even if it is a well-established fund providing solid returns, is likely to own stock in many of the same companies as your blue-chip fund. So even though you would own different funds, you could still be invested in many of the same companies.

Diversification tips

Many investment experts agree that you can build a diversified portfolio if you:

  • Balance growth investments with those that produce income
  • Buy stock in both large and small companies, as well as a mix of established and new companies
  • Look for stock of companies in unrelated market sectors
  • Seek stock of companies based in different countries, or mutual funds that invest in those countries
  • Consider some stock that is currently out of favor but that has the potential to increase in value

Diversity isn’t random

To be sure your portfolio is really diversified, and not just a random collection of investments, you need to analyze what you already own. Then, before you make any additional purchases, you should weigh each investment you’re considering, both on its own merits and for what it brings to your portfolio.

For example, if you already own two or three large-company stocks in traditional industries as well as a small-company stock fund, your next investments might include a specialized index fund, an international fund, and the stock of one or two medium-sized, well-managed companies. Or, if the stock you own is focused on growth, it might be time to buy a tried-and-true blue chip company that provides dividend income as well as growth potential.

Ideal Numbers

One approach to diversification is that you try never to have more than 10% or less than 5% of your portfolio in a single investment. While it’s not always practical, or even possible, it’s worth considering.

Reasonable expectations

Part of making investment decisions is to evaluate the potential return you can reasonably expect from different categories of investments. While past performance can’t ever predict future returns, either for a single investment or a group of investments, it can give you a sense of what’s possible.

For example, large company stocks based in the US have provided returns averaging 9.8% since 1926, based on information published by Morningstar, Inc. While you can’t be sure the next ten years will provide the same level of return, you can be reasonably sure the long-term average won’t hit 20% or 30%, even if returns spike for one or two years as they sometimes do.

Similarly, you should be aware of how volatile certain investments can be, since the possibility of frequent or sudden changes in value may affect the choices you make if you’re investing to meet specific goals. Small-company stock prices, for example, may fluctuate dramatically in price even in a period when large-company stock prices hardly change at all.

 

 

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