One of the easiest steps to help lower the volatility in your portfolio is the power of diversification. Along with diversification among asset classes (i.e. stocks, bonds, cash, precious metals) the types of stocks and bonds an investor owns should be diversified also. Stocks within each sector and industry tend to move in step with each other outside of micro-economic factors, but other sectors and industries can move in opposite directions. Maintaining a portfolio of stocks in only one sector or even worse in only one industry can, on occasion, provide strong growth opportunities, but in the long run this single track focus will not stay as profitable as a diversified portfolio will. To profit from a single industry approach an investor would have to be able to time the bottom and top entry and exit points. A well diversified portfolio will lose less when one sector turns bearish.
Two easy references to illustrate this lesson are the tech bubble and the housing bubble. Many investors who tried to ride this wave for too long with too much of their portfolio ended up with less than they started with. These are not the only bubbles that have popped and certainly won't be the last. Here are five tips to help diversify:
- Know what you own – Yahoo! Finance is offers easy tools for free to help organize holdings by sector and industry. Keeping this table of what sector/industry your investments are in allows you to maintain a more balanced portfolio without having to guess.
- Own enough to be able to spread it out – Hold at least seven stocks at any time (10-12 is even better) – Too few stocks cause portfolio fluctuations to be too dependent on each stock. For someone just starting to build a portfolio of investments, don’t feel like you need to jump into stocks too soon. Choose an index mutual fund or better yet an ETF that mirrors the broader markets until you have enough cash to spread across seven or more different stocks. Each mutual fund or ETF diversifies within its own scope, but multiple funds are needed to truly diversify among multiple asset classes and company sizes.
- Don’t spread it too thin – Hold no more than 20 stocks at any time – Too many stocks “water down” the benefits of the good picks you make and are too hard to track for most small investors. Limiting yourself to no more than 20 stocks in your account at any given time can be a great tool for encouraging better research. An investor who knows she cannot load up on any stock that passes before her eyes tends to make more thoughtful decisions. That gives this limit a double benefit.
- Hold different size companies - Just as stocks within a certain sector can move in unison, so can stocks with similar sizes. By holding different size companies you remove the risk of being left behind if one group moves more than another.
- Diversify by beta – Diversifying by sectors and industries will handle most of the diversification process, but you can do more. You have to be quite as diligent with diversifying by beta, but it can help smooth out the peaks and valleys. Beta is the monthly price change of a stock compared to the S&P 500. This is especially useful for the investors who are more risk averse and still have a hard time with the emotional side of investing. A helpful move is to choose stocks that balance the average beta as close to 1.00 as possible. This leaves room for some stocks to move with the market while others might move against the market. If you diversify well by sector and industry, you typically find this beta averaging will take care of itself. (You can find a stock’s beta listed in Yahoo! Finance in the “Key Statistics” section in the top of the right column.)
