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Importance Of Diversification

You’ve heard the pronouncement before. “This one’s a sure winner.” Well, in the stock market nothing is a guarantee. Even with research and all of their resources, investment professionals are not always right. There are too many unknowns and too many variables to be always right, all the time. That’s the primary reason why the professionals recommend and diversify their own stock portfolio. But how you do that wisely so that, at the end of the day, you come out ahead?

How much diversification should you have?
There has been a great deal of debate over how much diversification is best. Many experts say that, for the average investor, they should diversify enough to provide broad exposure to the market but not so much that they cannot follow the stocks they own.

In other words, a portfolio of 15 technology stocks is not a good way to diversify. A portfolio of one stock in 15 different industries is also not necessarily a good example of diversification. A portfolio of more than 25 stocks would be difficult to monitor for the average individual investor.

Generally, you should have investments in at least three or four stocks in at least four or five different industries. Spreading your investments over different stocks in different industries reduces losses if one of your investments is in the wrong industry. It also reduces risk if you purchase the wrong stock in what normally is a strong industry.

Diversifying the timing of your purchases
You can also diversify your portfolio and reduce risk by making your investments over a broader period of time. Historically, the stock market goes through cycles of ups (referred to as a bull market) and downs (bear market). Whether it’s good to buy or sell a particular stock is also a function of whether the market is rising or falling.

However, no one can predict short-term movements in the stock market with any degree of accuracy. But if you spread your investments over time, you can minimize the risk of making all your purchases when stocks are at the top of a bull market.

There are two types of risk that are reduced with this timing strategy. First, it reduces the risk of losing a significant part of your money quickly. Who doesn’t dread making an investment and then see the market drop dramatically? By diversifying the timing of your investments you can also hedge against price volatility. In other words, the average price for the stocks you buy over time will probably reflect the average market values for that period.

Taking stock of your portfolio
Diversifying the stocks you buy and when you buy them will not eliminate the risk of making bad investment choices. But it can greatly reduce those risks. Moreover, practicing diversification will enable you to develop discipline in your investment strategy.