03) Financial Concepts: Diversification

by · October 6, 2010

A lot of individual investors cannot tolerate short-term fluctuations. In order to smooth out the ride, you should diversify your portfolio

Diversification is a risk-management technique that mixes a wide array of investments within a portfolio, ultimately reducing the impact of any one security on the overall performance of the portfolio. It, therefore, lowers the risk on your portfolio. To demonstrate:

Let’s suppose that you live in an island where the entire economy relies only on two companies – one selling umbrellas, the other sunscreen. If you invest your entire portfolio in the former company, you can expect a strong performance during rainy season. Alternatively, you will experience a poor performance during sunny season. The same is true with the sunscreen company. When the sun is out, you gain; when the clouds roll in, profits fall. A better alternative would be to have a constant and steady return. It would therefore be ideal to invest 50% in one company and another 50% in the other company. Because of diversifying your portfolio, you will ensure a steadier performance year round instead, rather than being tethered to a really good and really bad performance dependent on season. To help ensure the best diversification, three main practices are helpful:

1) Diversify or spread your portfolio among different investment vehicles. These can be in the form of bonds, mutual funds, stocks, or real estate.

2) Securities must vary in risk. Do not restrict yourself to choosing only blue chip stocks. This is to ensure that losses are offset by gains in other areas.

3) To help minimize industry-related risks, vary your securities by industry.

Diversification is a major tool that will help you reach your long-range financial goals while decreasing risk, but one must remember that there is no ultimate guarantee against loss. Remember, though, that investing will always involve varying degrees of risk in one form or another.

A question often asked by new investors is “How much is enough stocks to buy to reach maximum diversification?” If we base it on the portfolio theory, around 20 securities to your portfolio will lessen the individual security risk involved, assuming that you buy stocks at different industries and at various sizes.