Diversification doesn't guarantee against losses, but it narrows the range of potential outcomes.
WASHINGTON, DC -- This month at The Motley Fool we've dedicated ourselves to getting back to basics, culminating on 25 September with Worldwide Invest Better Day. With this in mind, my Foolish colleagues and I are unleashing vital information to help you invest better. Today, we'll review stock diversification, a key fundamental of investing.
Think of a well-performing portfolio like a properly made seven-layer cake. Applying layers of diversification to your stock portfolio increases your odds of investing success. First we'll address why diversification is so important, then we'll dive into the delicious layers one by one.
Why all this diversification mumbo jumbo?
At the core of diversification lies the idea of correlation, a measure of how the returns of two investments move together. Some investments' returns move in the same directions; others move in opposite directions. The goal of diversification is to own a basket of investments whose returns move in opposite directions so that even if a portion of your portfolio is deteriorating, the rest of your portfolio is growing. In essence, we potentially mitigate the impact of poor market performance on our overall portfolio. Diversification doesn't guarantee against losses, but it narrows the range of potential outcomes.
Let's take a closer look at what I call the seven layers of stock diversification.
1. Target how many stocks to own
Studies have shown you can achieve a well-diversified portfolio with as few as 15 and as many as 30 stocks. If individual stocks are to make up the majority of your portfolio, shoot for 25 to 30. To avoid concentrating too heavily in any one stock or sector, keep your stock portfolio at a minimum of 15. Contributing a set amount of money at regular intervals is a strategy you can use to buy a specific number of stocks over a period of time.
2. Don't overconcentrate
Fidelity feels an investor should have no more than 5% of their total portfolio in any individual stock; others think 10% is more realistic. Depending on whom you listen to, this answer will vary. But regardless of whose advice you heed, don't put so much money in any one holding that if you lost it all you'd be heartbroken or destitute.
3. Balance across sectors
Sectors perform differently during bull, bear and flat markets. Those considered "defensive", including consumer staples, utilities, telecom and health care, typically aren't as affected by a downturn in the economy as the more economically sensitive sectors like industrials, energy, financials, consumer discretionary and tech. A portfolio that includes all sectors has the best chance for success over the long haul regardless of market conditions.
4. Dig deeper into subsectors
Let's take the tech sector as an example. Within it there are companies that specialise in hardware, software, semiconductors and communications equipment. Owning only ARM Holdings (LSE: ARM) puts you at risk if something detrimental happens to the semiconductor market. But adding Apple (NASDAQ: AAPL.US), a company that sells iDevices and a bunch of related services, gives us a deeper level of diversification within the sector.
5. Screen for suitability
Stocks are categorised into different market capitalisations, or sizes, including small, mid and large caps. Stocks also pay different degrees of dividend income to shareholders. Do you need income now or can you forgo it? Your answer may lead you to skew your portfolio toward either more income-producing dividend stocks or more growth-oriented non-dividend-payers. An investor hungry for income is likely to find SSE (LSE: SSE) and Royal Dutch Shell (LSE: RDSB), with their respective 6.5% and 5% dividend yields, far more palatable than a small-cap non-dividend-payer. Even though the two companies are managed very differently from each other, they are similar in generating mouthwatering dividends for income-desiring investors.
6. Don't forget about international exposure
Geographical diversification counts, too. ASOS (LSE: ASC) derives 65% all of its business from international sales now, while Imperial Tobacco (LSE: IMT) is an example of a company profiting from increasing sales in emerging markets.
7. Monitor and maintain balance
Once we've built a beautifully layered cake, let's not take our eyes off it only to have it topple over. In order to maintain balance, we need to monitor our portfolios. Sometimes the hardest part of being an investor is selling winners and rebalancing, but smart investors do this systematically and free of emotion.
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> The Motley Fool does not own any shares in any of the companies mentioned.