The Importance of Stock Diversification for Your Investment Profile

admin | June 18, 2018 | 3 | Boost Your Net Worth

Successful investment is all about mitigating risk, and mitigating risk is all about diversification. A well-diversified investment portfolio can be the difference between a lifetime of steady financial gains and losing it all after one unlucky break.

How do you successfully diversify? In this article, we’ll show you the basics, starting with stock diversification.

Read on and take your first step toward building an invincible investment portfolio.

Why You Should Diversify Your Portfolio

Diversification is important in investing because it helps you reduce risk. If you put all your money in one company’s stock and that company goes under, you lose everything. If you spread your money across an entire industry and that industry takes a hit, you take the hit too.

You can’t always predict the downfall of a company or industry. Imagine you had bet it all on Enron in the 90’s or on real estate in 2007. Protecting yourself from these unpredictable (and predictable) shocks is what diversification is all about.

When diversifying your portfolio, you should be thinking about the two major types of risk. The first is ‘diversifiable risk.’

Diversifiable risk, also known as unsystematic risk, is the risk that affects individual companies and industries but not the entire economy. A well-diversified portfolio is almost invincible to this type of risk.

The second is ‘undiversifiable risk.’ As you can tell from the name, undiversifiable risk is much harder to get rid of. This risk is also known as systematic risk, and it’s associated with shocks that affect the entire economy.

In theory, these shocks hit everyone’s portfolio. But later on in this article, we’ll show you some ways you can soften the blow.

How Do You Diversify Your Portfolio?

Financial diversification has many possible dimensions and, within each dimension, many possible layers. For example, you can diversify across different types of assets such as stocks, bonds, commodities, and even cash. And you can further diversify within each of these dimensions, going as far down the rabbit hole as you like.

If you’re willing to put in the time and effort, you can create a broad and deep portfolio that will survive almost any economic shock.

Let’s start with the most important dimension: stock diversification.

Stock Diversification

As we said above, one of the most important parts of diversifying stocks is making sure they come from as many different industries as possible. You don’t want to be exposed to any kind of unsystematic risk and you shouldn’t assume that any company will be around forever.

But there’s more to it than that. For example, an S&P 500 index tracking fund is often considered a healthy, diverse investment. But if you held one of these index funds for the decade from 2000 to 2009, you would have ended with less money than you started with.

Now yes, that decade did see two significant stock market crashes, including one of the worst of all time in 2008. But believe it or not, if you had diversified your stock portfolio to include a healthy mix of medium and small-sized companies, you could have finished the decade with more money than you started with.

We know what you’re thinking: how could you ever have chosen that “healthy mix” of medium and small-sized stocks? Well, many financial institutions offer mutual funds designed to do just that. You just have to shop around.

You should also diversify stocks geographically. Most investors have what’s called a home country bias. They live, work, and shop in their home country, so they’re more likely to invest in their home country.

This bias exposes you to risk. You can be as diverse as you want, but if all your stocks are from American companies and the American economy crashes, you’re going to lose money.

The point is to diversify in every way possible.

Using Correlations

If you want to go the extra mile (and you should), look for stocks that are negatively correlated. That means that if one stock increases in value, the other one will probably decrease. This will further help stabilize your portfolio.

Finding stock correlations is an advanced skill but it’s one that every expert stock trader should have in their toolbox.

Diversification Beyond the Stock Market

There’s much more to diversification than buying a variety of stocks. And at the end of the day, investing in the stock market is inherently risky.

That’s why, if you really want to diversify, you need to invest in other types of assets as well. Bonds are a safe, reliable investment, that should be included in everyone’s portfolio.

You probably won’t get rich investing in bonds, but you will get steady returns. They’re the perfect investment for those of you who aren’t looking to gamble. And bonds actually outperformed the S&P 500 in the tumultuous decade from 2000 to 2009.

Some investors diversify their portfolios even further by investing in commodities such as oil or gold. Gold prices often climb during times of economic stress, so buying gold can be a great way to hedge your bets.

Of course, it doesn’t end there. You can diversify across different currencies, you can invest in real estate in different parts of the world, and you can even set a little bit of cash aside in case everything else goes south.

By now, you’ve probably realized that the possibilities for diversification are endless. It’s an artform that’s as intricate as it is important. While we encourage you to learn all you can about stock diversification, there are also great online resources that can help you out, such as this company.

Start Diversifying Today

Investing is all about playing the long game. It’s ok to take some risks here and there in the hopes of making it big, but you should always be well-diversified in case your risks don’t pan out. Stock diversification and asset diversification should be the backbones of your investment strategy.

With some research, patience, and luck, you may just end up on our Net Worth blog someday.

If you found this article helpful, be sure to check out the other articles in our blog on how to boost your net worth.