Understanding Stock Diversification
We've all heard about the value of diversification in reducing risk in our portfolio, but be sure you understand that there are two types of diversification.
The purpose of diversification is to reduce volatility and improve overall performance. It works if you do diversification correctly.
The first type of diversification is the one most commonly understood as don't put all your eggs in one basket.
This simply means don't just own one or two stocks. One common way people get in trouble is owning too much of their employer's stocks.
You may get a good deal on company stock and load up in your retirement fund and buy more for your investment fund because you believe in your company.
It may even seem disloyal not to buy lots of company stock. However, it is not in your best interest if most or your entire portfolio in your company's stock. Think Enron.
To be truly diversified in your stock selection, you need to own stocks in different industries (even different countries) and in different size companies.
You want your investments spread over large, medium and small companies in a variety of industries. It is especially important to watch the relationship between the stocks so they are not all affected by the same economic factors.
For example, if all of the stocks you owned were extra sensitive to interest rates, then you would not be diversified. The stocks would move in correlation with the interest rates and each other.
Stocks that have a low degree of correlation don't move as one unit and therefore are less likely to react the same way to the bad economic news.
The lesson here for investors is that if a sector of the market is really hot, avoid the temptation to dump "all your eggs into one basket." However, you should also be aware of those market or economic influences that may adversely affect a group of your stocks.
Don't put all your eggs in one basket and don't put all your baskets in the same wagon.
Another type of Diversification
Another type of diversification involves the other parts of your portfolio.
If you tie up all of your investments in stocks, no matter how uncorrelated, you are still not diversified in the sense of reducing risk and improving performance.
You need to also spread your investments over different asset classes such as bonds, cash, real estate, and other alternative investments.