Diversification is key for high returns on stocks, and this includes not putting all your investment eggs in one basket. Pay attention to these five steps to diversify your stock portfolio:
1. Monitor Your Portfolio
To maintain a diversified portfolio of stocks, an investor must monitor his or her portfolio. It is not enough to simply set up a diversified portfolio and assume that the portfolio will remain diversified. Investors should check on their stock portfolios regularly (at least monthly), and be ready to adjust their holdings appropriately.
There are a variety of reasons why a stock portfolio may become concentrated when it originally was diversified. One way this can happen is if one stock or group of stocks held by an investor is exceptionally successful compared to the rest of the investor’s portfolio. In this case, the investor’s portfolio becomes concentrated in favor of those stocks which appreciated.
Another reason an investment portfolio may become unbalanced are changes in corporate strategy. Acquisitions can drastically change a company’s focus, strategy, or even its industry. And a change in a company’s core markets could likewise create an unwelcome concentration in certain markets for an investor. For example, consider IBM’s change from a seller of hardware and mainframes to providing technical services.
An investor who is completely passive and does not monitor his or her portfolio could end up with an unduly concentrated portfolio, even if the portfolio was originally well-diversified.
2. Diversify Among Sectors
To create a diversified stock portfolio, it is essential that investors be sensitive to industry and sector diversification. An investor who simply divides his or her investment among a number of stocks may not be diversified if those stocks all represent similar bets on consumer trends or the business cycle.
Thus, investors should check their portfolios to see if the stocks they own are diversified by industry and by sector. A company’s industry and sector information is easily identified in the most basic research information available on the company.
An investor would not be considered diversified if a significant percentage of his or her holdings were in one sector; being concentrated in one industry could be even more catastrophic. Industries and sectors wax and wane in importance in the economy, and many industries have, in the long term, no surviving firms. Thus, to avoid the risk of the decline of one industry or one sector, an investor should ensure diversification among many industries and sectors.
3. Diversify Geographically
Just as an investor is not diversified if he or she is concentrated in one industry, an investor who owns stocks in companies dependent on one geographical area is not diversified.
The reason for geographical diversification is that companies that are otherwise unlike each other could be all dependent on one geographical area. For example, a nation may undergo a recession or slowing growth, while other nations do better. Or a geographic area or nation may undergo a disaster or political crisis that could hamper the ability of companies operating in that region.
Diversifying geographically should also mean diversifying among different kinds of economies. An investor could own investments in many different countries, but still be unwisely concentrated in developing or developed economies. An investor with investments spread widely among developing economies still risks the decline of all developing economies at once, an occurrence commonly seen during the flights to safety that occur in times of economic uncertainty.
4. Diversify By Company Size
No portfolio is truly diversified unless the portfolio contains stocks of companies of different sizes (i.e., market capitalization). Even though an investor may be diversified in other ways, it is important to diversify by market capitalization.
Because companies with large market capitalizations have a different market for their shares than companies with small market capitalizations, an investor should try to diversify his or her holdings by market size as well. “Large cap” stocks, “small cap” stocks, and stocks with medium market capitalizations also may have different underlying risks and ability to access capital on favorable terms. This is especially true in the financial industry, where large firms may be subject to different political risks and implicit guarantees than small firms.
5. Diversify for Business Cycle Risk
An investor should take care that his or her portfolio is not unduly concentrated in companies or industries that tend to perform similarly throughout the business cycle. For example, although a transport company, a company producing automobiles, and a mining company are all in different industries, all tend to suffer more than the broad market during a downturn in the business cycle. Similarly, all tend to benefit more than the broad market by an upswing in the business cycle.
Therefore, an investor should consider how a company is likely to react relative to the market. An investor should be prepared to alter his or her stock portfolio if a large percentage of the portfolio tends to react the same way to changes in the business cycle. Examples of industries which react less sensitively to the business cycle are consumer staples and health care.
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