Until you’ve unearthed a gem few other people have noticed, until you’ve found the wheat among the chaff, and until you’ve taken a bold step toward your financial goals based on your own analysis, you can’t possibly understand how it feels to pick a winner. Once you do achieve some success selecting stocks, you’ll probably get the itch to dive back in and find a bunch more. This kind of enthusiasm is good, but don’t rush it.
At a time when the market is booming, it is almost impossible to sell a stock for less than you paid for it. However, since we cannot predict what market conditions will be at any given time, a well-diversified portfolio is essential regardless of market trends.
When it comes to developing an investment strategy that mitigates losses in a bear market, the investment community teaches the same thing that the real estate market preaches: “location, location, location.” Simply put, you should not put all your eggs in one basket. Diversification is based on this premise.
Here are five tips to help you make smart decisions and learn why diversification is important to your portfolio.
What Is Diversification?
Diversification is a rallying cry for many financial planners, fund managers, and individual investors. Mixing investments in a single portfolio is a management strategy. The concept of diversification is that a variety of investments leads to higher returns. Investing in a variety of asset types also reduces the risk for investors.
Sometimes, one company will make a big mistake that sends its stock into the toilet while its rivals do just fine. Sometimes technology stocks will lag while healthcare stocks set the pace.
And sometimes most stocks will decline while bonds rise in value. If you invest, you’ll likely encounter each of these phenomena. Diversification is a simple thing you can do to provide some protection against all three.
Best Ways to Help Diversify Your Portfolio
The concept of diversification is not new. The luxury of hindsight allows us to observe the movements and reactions of markets as they faltered during the dot-com crash, the Great Recession, and again during COVID -19.
To practice disciplined investing with a diversified portfolio before diversification becomes a necessity, it is important to remember that investing is an art form, not a reaction. 80% of the damage is done by the time the average investor reacts to the market. A well-diversified portfolio combined with an investment horizon of five years can weather most storms here better than anywhere else.
The following five tips will help you diversify:
1. Buy multiple stocks
Owning 25 to 35 stocks provides the best blend of risk and return. Go with too few stocks, and you take the chance of a couple of stinkers spoiling all the fun. Go with too many, and you lose the benefit of selecting individual stocks. Plenty of investors become stock collectors—buying whenever they find a stock they like, holding them for years, and creating their own little index fund along the way.
Why don’t all investors just stick with a portfolio of 25 to 35 stocks? It boils down to two main reasons, one more legitimate than the other.
First, many investors think, “I don’t have enough money to buy 25 stocks.” For the most part, they’re wrong. With discount brokers, investors can purchase stock in $1,000 bites, rather than in 100-share lots. The commission costs can get a bit high with small purchases, but true diversification should save you more in the long run than you’ll spend on a few $10 commissions. And even if you only have $1,000 to invest, you can diversify. Spend the money on a stock. Then, when you’ve set aside another $1,000, buy a second stock rather than more shares of the first one.
Second, investors often worry about whether they can keep up with the news on 25 stocks. This objection has some merit; it does take time to follow stocks.
If you just don’t have the time, you can certainly buy fewer than 25 stocks. Just remember that when you limit the size of your portfolio, you sacrifice some of the benefits of diversification.
2. Buy different types of stocks
Standard & Poor’s breaks the market down into 10 sectors:
- Consumer discretionary
- Consumer staples
- Health care
- Telecommunication services
Most of the sector names require no explanation. Both consumer staples and consumer discretionary include companies that provide goods or services to consumers. Discretionary stocks (which include hotels, automobiles, clothing, and most types of retail) tend to see their results strengthen and weaken based on economic trends. Staples stocks (grocery stores, tobacco, household goods, and beverages) do business in markets that see less variance because of economic forces.
The materials sector contains companies that produce such goods as chemicals, steel, and paper. Telecommunications services—by far the smallest group—consists of companies that provide telephone service.
Cyclical groups tend to see their revenue ebb and flow in cycles, and they include consumer discretionary, industrials, materials, and some technology stocks. Noncyclical sectors include consumer staples, most health care stocks, telecommunications, and utilities.
The other sectors include a mix of cyclical and noncyclical stocks, plus a few that simply follow their own paths. It’s best to take the “cyclical” and “noncyclical” labels as guidelines rather than rules, as you can find both types of stocks in every sector. The stock market provides investors with far more gray areas than black or white.
Not every investor needs to own stocks from all 10 sectors. But if your portfolio doesn’t feature stocks from at least six of these groups, you probably haven’t diversified enough. You should also vary your stocks by size.
Remember that large caps tend to be safer, while small- caps tend to offer greater growth potential. Last, adding foreign stocks can also diversify your portfolio and possibly boost returns as well. Just remember that you may have more trouble keeping up with the news on foreign stocks—particularly those in emerging markets. They’re also more likely to surprise you, both on the upside and the downside.
3. Buy different types of investments
Over time, stock prices tend to move with earnings—rising in value as the underlying company grows. On the other hand, bond prices fluctuate mostly based on interest rates. For example, if Acme Widget doubles its sales and profits over five years, the stock price will probably rise quite a bit. However, the price of Acme’s bonds shouldn’t change much, assuming steady interest rates and creditworthiness.
Investments that move together have highly correlated returns. If two securities have a correlation of 1.00, they move together step for step. A correlation of –1.00 means they trace exactly opposite paths, one rising while the other falls. On the other hand, a correlation of 0 means the movements are unconnected.
Large-company stocks and small-company stocks usually have a correlation of 0.72, implying somewhat similar movements, though not exactly the same.
Small-company stocks provide some diversification for a portfolio of large-company stocks, but not as much as long-term government bonds, which usually have a 0.06 correlation. The 0.06 correlation implies that the securities march to different beats, which means that relative to large-company stocks, bonds provide greater diversification than small-company stocks or most foreign stocks.
From 1926 through 2012, large-company stocks averaged annual returns of 11.8%, with a standard deviation of 20.2%, while long-term government bonds averaged returns of 6.1%, with a standard deviation of 9.7%.
That means that in roughly two-thirds of the years, stocks delivered returns between 32% and negative 8.4%. In contrast, bonds returned between 15.8% and negative 3.6% about two-thirds of the time—a much smaller range of outcomes.
In addition to being different in terms of risk and potential reward, the returns of bonds and stocks often diverge for long periods. That divergence is what makes diversifying your types of investments to include both so attractive.
Beginning investors should generally get their bond exposure through mutual funds. But by all means, capture that diversification benefit. Adding bonds to a stock portfolio reduces both returns and risk relative to a stock-only portfolio.
Return per unit of risk increases as you add bonds, topping out at about 70% bonds to 30% stocks. However, most investors should gravitate to a mix heavier in stocks, boosting the returns while keeping risk manageable.
While there is no way to guarantee that your stock portfolio will weather each and every economic storm, you decrease your risk of losing big with a diverse portfolio. With that, we look at some important questions every investor should ask themselves as they work toward building their perfect portfolio.
4. Dollar-cost averaging
Regularly increase your investments. You can use dollar-cost averaging if you have $10,000 to invest. Market volatility creates peaks and valleys, which are smoothed out using this approach. In this strategy, you invest the same amount of money over an extended period of time to cut down your investment risk.
Investing in dollar-cost averaging involves investing money regularly into a specified portfolio of securities. This strategy involves buying more shares when the price is low, and fewer when the price is high.
5. Pay attention to commissions
If you are not a trader, it is important to understand what you get for the fees you pay. Some companies charge a monthly fee, while others charge a transaction fee. They may not seem like much, but they add up.
Understand what you are paying for and what you are getting. Do not always opt for the cheapest option. Check to see if your fees have changed.
Learn more about the five types of investment you should consider for your portfolio.
Why Should You Diversify?
When one stock, sector, or asset class plummets, others may rise as a result of diversification. This is especially true if the securities or assets held are not closely correlated. By reducing overall portfolio risk, diversification maximizes expected return without sacrificing risk.
If the addition of a new investment increases the overall risk of a portfolio or reduces the expected return, diversification is not achieved. Over-diversification occurs when a portfolio already contains an ideal number of securities or when you add closely correlated securities to it.
Are Index Funds Well-Diversified?
Index funds and ETFs, by definition, track an index. The degree of diversification can vary depending on the index they track. In contrast, the Dow Jones Industrial Average has only 30 components, while the S&P 500 has more than 500.
Even if you own an S&P 500 index fund, it is not necessarily a diversified portfolio, as you should also include other asset classes with low correlation, such as bonds, as well as a modest allocation to commodities, real estate, and alternative investments.
Investing can and should be fun. The process can be informative, educational, and rewarding. Even in bad times, investing can be rewarding for you if you use diversification, buy and hold, and dollar-cost-averaging strategies.