Whether you’re a new investor or you’ve been in the investing game for a while, one word that you’ll hear repeatedly is diversification. The reason for this is simple and important. Diversification is essential for mitigating risk.
There are several different ways to diversify your portfolio, but keep in mind that any big financial decisions should be made with a trusted financial advisor or after you've done a lot of important homework. It's also important to remember that too much diversification can be dilutive and costly.
The most fundamental level of diversification is security diversification. Here, the risk is 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 as more stocks are added to a portfolio, but at a decelerating rate. Owning too few stocks is risky, but owning too many can be dilutive. It can also be very costly, and it’s certainly hard to keep up with the news and financials of a large number of companies. For optimal security diversification, it’s best to talk to an expert about how many stocks should be in your portfolio. A trusted advisor can suggest a strategy that will provide the benefits of security diversification without going overboard.
Sector diversification is extremely important to consider. Sectors are a particular group of stocks within a specified economic market. To be too heavily weighted in one sector could cause nothing but a headache if that sector takes a big hit. Consider the 2008 financial crisis. To say that the financial sector was hit hard is an understatement. Anyone who held a large number of bank stocks probably saw their net worth drop dramatically, practically overnight.
Here’s a list of the market’s main sectors:
- Consumer Discretionary
- Consumer Staples
- Basic Materials
- Communication Services
- Health Care
Remember, individual sectors of the market can and do produce widely divergent returns, depending largely on economic conditions. Investing in only a limited number of sectors can increase the volatility (risk) of returns.
The next level of diversification is industry diversification. It is entirely possible that securities share the same sector, but not the same business focus. Let’s take the technology sector as an example. There are companies that focus on making computers, others that make components for computers, and yet others that develop software. And this is barely scratching the surface when it comes to technology. In the healthcare sector, you will find companies that produce medication, others that develop medical equipment, and others that are working to find cures for disease and illness. As you can see, you can widely diversify your investments within a given sector.
The next level of diversification market capitalization. No doubt you are used to hearing or reading the terms large-cap, mid-cap, and small-cap stocks on a daily basis. As a review, capitalization is simply the price of a company's stock multiplied by the number of shares outstanding. For example, a company whose stock price is $25 with 10,000,000 shares outstanding has a market capitalization of $250,000,000. The levels of capitalization are determined by their market cap:
- Large Cap Stocks- large-cap stocks typically have a capitalization in excess of five billion dollars. Some examples might be General Motors, Microsoft, and Coca-Cola. Large-cap stocks are less risky than mid-cap and small-cap stocks, which also means that they tend to generate the least return (less risk = less return). The value of large-cap stocks is tracked by two major indices, the Dow Jones Industrial Average (INDU) and Standard & Poor's 500 (SPX).
- Mid Cap Stocks- mid-cap stocks typically have a capitalization of between one and five billion dollars. Stocks of companies in this sector of the market offer investors the opportunity to invest in companies more seasoned than their small-cap counterparts, but they aren’t as large as large-cap stocks. The S&P 400-MidCap Index (MID) is the most appropriate benchmark for following mid-cap stocks and provides a value-weighted index of 400 stocks.
- Small Cap Stocks- small-cap stocks are generally those of smaller, growth-oriented companies with a capitalization of up to one billion dollars. Small cap stocks are knowns for being the riskiest group of stocks but also offer the greatest return potential. There are two main indices that track these stocks. One is the Russell 2000, which tracks 2,000 stocks that only represent 10% of total U.S. market capitalization. The other small-cap index is the well-known NASDAQ (National Association of Securities Dealers Automated Quotations Composite), which is a cap-weighted index that measures the performance of over-the-counter securities.
Geographic diversification deals with developing portfolios that contain both international and U.S. stocks. The past shows us that portfolios containing both international and domestic stocks have had lower overall risk levels than those invested exclusively in one or the other. However, it takes a seasoned investor to be comfortable with investing in international stocks.
Investment Style Diversification
Investment style diversification is the way that you, as an individual investor, manage your portfolio. Investment styles tend to move in and out of favor in the market, with one style outperforming the other over certain time periods. For this reason, selecting one particular style can be quite risky. Below find a very brief overview of the three main styles of investing:
- Value- this approach seeks out companies that seem to be undervalued by the current market
- Growth- this approach seeks to identify companies that may grow faster than the market
- Indexing- this approach is a neutral approach and tends to try to replicate a market index
Remember, diversification is an important way to reduce risk, but too much diversification can be dilutive and costly. Be sure to do all of your homework and always consult a trusted financial advisor before making any big decisions.
This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.