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Diversification: The One True Rule for Reducing Risk in Your Portfolio

Successful investing requires a strategy that both maximizes potential growth while limiting risk. While there are many growth strategies, I believe to reduce risk investors should diversify.

Diversification – you know, putting your eggs in several different baskets – is an investment strategy to help with weathering market turmoil. There are several ways to diversify your investments. Here’s a primer on this important concept to help you determine whether your portfolio is adequately diversified.

Security Diversification – This is the most fundamental level of diversification. Risk is reduced by increasing the number of different stocks in the portfolio. The big question is how many stocks should you 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 can be risky, but owning too many could dilute your potential returns. A portfolio with a large number of stocks can also be expensive and difficult to manage. Consider talking to a financial professional 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 –  A sector is simply an industry or group of related industries. If you are excessively invested in one sector, your portfolio could be vulnerable to large losses if that industry takes a big hit. Consider the 2008 financial crisis. 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:

  • Utilities
  • Transportation
  • Technology
  • Consumer Discretionary
  • Industrials
  • Consumer Staples
  • Utilities
  • Financials
  • Energy
  • 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 could increase volatility in your portfolio and put your returns at higher risk.

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Industry Diversification –  Securities can share the same sector, but not the same business focus. Let’s take the technology sector as an example. Some companies focus on making computers, others make components for computers, and yet others develop software. In the healthcare sector, you will find companies that produce medication, others that develop medical equipment, and others that own hospitals.

As you can see, you can – and I believe should — diversify your investments within a given sector.

Capitalization Diversification –  Capitalization is merely 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 typically have a capitalization over of five billion dollars. Some examples are General Motors, Microsoft and Coca-Cola.  Large-cap stocks are considered less risky than mid-cap and small-cap stocks, which also means 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 and Standard & Poor’s 500.
  • 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 that are more mature than their small-cap counterparts, but not as large as large-cap stocks.  The S&P 400-Mid Cap Equity Index is a benchmark for following mid-cap stocks.
  • Small Cap Stocks are those of growth-oriented companies with a capitalization of up to one billion dollars. Small-cap stocks tend to be the riskiest but could offer the greatest return potential. There are two main indices that track these stocks, the NASDAQ and the Russell 2000.

Geographic Diversification. Market history teaches that portfolios containing both international and U.S. domestic stocks have had lower overall risk levels than those invested exclusively in one or the other. However, investing in global stocks requires a great deal of knowledge and experience.

Investment Strategy Diversification. Investment strategies tend to perform cyclically, with one approach outperforming the others over a specified time period. For this reason, selecting one particular style can be quite risky.

Here’s a brief overview of the three main investment strategies:

Value seeks out companies that seem to be undervalued by the current market.

Growth tries to identify companies that may grow faster than the market.

Indexing is a neutral approach that tries to replicate a market index.

So, how does your portfolio measure up? Or perhaps, measure “around.” If you are overly concentrated, start thinking about how you could spread your assets across the market prudently. The result could be an effective layer of protection that can limit your downside and allow you to focus on boosting the upside.

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