One of the greatest investing lessons I’ve learned is the power of diversification. Jim Cramer likes to close his Mad Money show by saying “there’s always a bull market somewhere”. I think he could continue to say there’s always a bear market somewhere, but that wouldn’t sound as fun. I doubt there has been a day where every single stock is down. Stocks within each sector and Industry tend to move in step with each other, 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. I’ve never read of an investor who has the skills to get this right on a long term basis. Your portfolio has a fighting chance when one sector turns bearish if you have stayed diversified.
1. Keep a trader’s journal – Part of any trader’s journal should include a section to analyze balance and diversity. The easiest way to make sure you do what you plan is to write it down. Even if you are the only one to read it, writing down your breakdown of what you own will keep you a little more focused. That goes for anything in life, but those details can be found on someone else’s blog.
2. Know what you own – I use Yahoo! to help me sort my holdings by sector and industry. Keeping this table of what sector/industry I’m invested in allows me to maintain a more balanced portfolio without having to guess. You can see on my Current Portfolio page how I’ve broken down my holdings.
3. Own enough to be able to spread it out – Hold at least 5 stocks at any time – Too few stocks cause portfolio fluctuations to be too dependent and each stock. For someone just starting to build a portfolio of investments, don’t 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 five different stocks.
4. Don’t spread it too thin – Hold no more than 10 stocks at any time – Too many stocks “water down” the benefits of the good picks you make and are hard to track for most small investors. Limiting yourself to no more than 10 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.
5. Diversify by beta – Diversifying by sectors and industries will handle most of the diversification process, but you can do more. I don’t think 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.)
I learned my lesson in the tech bubble when I was first starting to trade stocks on a more regular basis. Tech stocks were all the rage and I wasn’t going to take the chance of missing out. Most of what I owned was in tech. I did great until the bust and ended up with less money than I started with. In the middle of it I asked a friend about why he wasn’t trying to diversify his account since I knew he was all in tech. He said he considered his account to be diversified. He had application software companies and networking devices and semiconductors too. He lost more than I did in the bust. We both stay well diversified now.