Whether you are a new investor or have been in the investment game for a while, one word you will hear frequently is diversification. The reason for this is simple and important. Diversification is essential for reducing risk.
Security Diversification
The lowest level of diversification is security diversification. Here, risks are reduced by increasing the number of different stocks in the portfolio. The big question here is how many stocks you should own to be properly diversified. Studies have shown that the level of diversification continues to increase with the addition of more stocks to the portfolio, but at a slowing rate. Owning too few stocks carries risks, but owning too many can be very costly and difficult to keep track of news and financial information for many companies. To achieve the best security diversification, it is advisable to consult an expert about the number of stocks that should be in your portfolio. A trusted advisor can suggest a strategy that will provide diversification benefits without overdoing it.
Sector Diversification
Sector diversification is very important to consider. Sectors are specific groups of stocks within a certain economic market. Being overly concentrated in one sector can cause significant problems if that sector takes a major hit. Consider the financial crisis of 2008. Let’s say the financial sector took a heavy blow; it would be an understatement. Anyone who owned a large number of bank stocks might have seen their net value plummet significantly, practically overnight. Individual sectors in the market can produce highly variable returns, largely dependent on economic conditions. Investing in a limited number of sectors can increase the volatility of returns.
Industry Diversification
The next level of diversification is industry diversification. Securities can share the same sector but not have the same business focus. Take the technology sector as an example. There are companies that focus on making computers, others produce components for computers, and others develop software. This is just a small sample within the technology field. In the healthcare sector, you will find companies that produce medications, others develop medical devices, and others work on finding treatments for diseases and ailments. As you can see, you can widely diversify your investments within a specific sector.
Capital Diversification
The next level of diversification is capital diversification. You have undoubtedly heard or read about large-cap, mid-cap, and small-cap stocks. As a review, capital is simply the share price of the company multiplied by the number of shares outstanding. For example, if a company’s stock price is $25 with 10,000,000 shares outstanding, the market capitalization of the company is $250,000,000. Capital levels are determined by market capitalization: large-cap stocks – typically have a market cap of over five billion dollars. Some examples might be General Motors, Microsoft, and Coca-Cola. Large-cap stocks are generally less risky than mid-cap and small-cap stocks, which also means they produce lower returns (less risk = less return). The value of large-cap stocks is tracked by two main indices, the Dow Jones Industrial Average (INDU) and the Standard & Poor’s 500 (SPX). Mid-cap stocks – typically have a market cap between one billion and five billion dollars. Stocks in this segment of the market offer an investment opportunity in more established companies than their small-cap peers, but are not as large as large-cap stocks. The S&P 400-MidCap (MID) index is the most appropriate benchmark for tracking mid-cap stocks and provides a weighted benchmark for 400 stocks. Small-cap stocks – generally, small-cap stocks represent smaller, growth-oriented companies with market capitalizations of up to one billion dollars. Small-cap stocks are considered the riskiest group of stocks but offer the greatest potential return. There are two primary indices tracking these stocks. One is the Russell 2000, which tracks 2,000 stocks representing only 10% of the total market capitalization in the United States. The other small-cap stock index is the well-known NASDAQ index (National Association of Securities Dealers Automated Quotations), which is a market-weighted index that measures the performance of over-the-counter securities.
Diversification
Geographic
Geographic diversification deals with developing portfolios that contain both international and American stocks. Past evidence shows us that portfolios containing international and American stocks have had lower overall risk levels than those that invested exclusively in one or the other country. However, an experienced investor needs to be comfortable investing in international stocks.
Diversification of Investment Style
Diversification of investment style is the way you manage your portfolio as an individual investor. Investment styles tend to move in and out of favor in the market, with one style outperforming the other during certain time periods. For this reason, choosing a particular style can be very risky. Below is a very brief overview of the three main investment styles:
- Value – This approach seeks to find companies that seem to be undervalued by the current market.
- Growth – This approach aims to identify companies that may grow faster than the market.
- Index – This approach is a passive strategy that attempts to replicate the market index.
Remember, diversification is an important way to reduce risk, but over-diversification can be costly and expensive. Be sure to do all your homework and always consult a trusted financial advisor before making any major decisions.
Disclosure
This information is provided to you as a source for informational purposes only. It is presented without regard to the investment objectives, risk tolerance, and financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks including the risk of losing the principal capital. This information is not intended to form the primary basis for any investment decision you may make. Always consult your legal, tax, or investment advisor before making any investment, tax, financial, or estate planning decisions.
Source: https://www.thebalancemoney.com/diversify-portfolio-added-protection-1289915
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