5) Risk and Diversification: Diversifying your Portfolio
With the stock market being so unpredictable, individual investors need a safety net. To address this need, diversification comes into the picture to help prevent the entire portfolio from losing value. While diversification does not guarantee against a loss, it is the most important tool in helping one reach their long-range financial goals at a minimal risk. But, it is important to remember that no matter how much diversification one does, the risk is never reduced to none.
There are three main things one has to do to make sure one is sufficiently diversified:
- Ensure that your portfolio is spread out among different mediums. These can be mutual funds, stocks, bonds, or real estate.
- Make sure securities vary in risk. Your choices are not limited to blue chip stocks. Choosing various investments with different return rates will make sure that large gains offset losses in other areas. Remember, however, that there’s no need to jump into high-risk investments such as penny stocks.
- Securities should differ by industry, reducing unsystematic risk to small groups of companies. To answer the question of how many stocks a person should buy, the portfolio theory says that after 10-12 stocks, this is as close as optimal diversification. This means that one should buy stocks of different sizes and from several industries.