10 TIPS FOR PERFECT DIVERSIFICATION
Ask an investor what the key to successful trading is and it's likely that you'll hear one of two answers: 1. A long term investment horizon and 2. A diversified portfolio. Although neither of these things can guarantee success on the stock market, by properly utilising both components in your investment strategy, you can minimise your risk and maximise your chance of reaching your long term investment goals.
Here are 10 ways to perfectly diversify your portfolio so you can do just that:
1) INDEX FUNDS
Investing in an Index fund is a quick and easy way for those of you without the time and resources to research and manage a portfolio of individual stocks to ensure that your portfolio is diversified. The average mutual fund holds 100-150 different stocks therefore allowing you to own a tiny slice of lots of different stocks and spread your risk as much as possible.
If you do plan to invest in an index fund, be sure to check its focus as some funds will specialise in a specific sector. If you want to truly diversify your portfolio across a range of sectors then it's likely that you'll need to own multiple ETF's/mutual funds. However, as this is such a low risk strategy, it comes with a smaller change of high rewards and may include commissions.
2) PICK 15-25 STOCKS
If you decide that, like many investors, you'd rather pick your own stocks then make sure to include a variety of different companies in your portfolio. This will limit your losses and reduce fluctuations as, as one area of the market falls, your other investments may be in a position to counteract those losses.
I personally think that 15-25 is a good number of stocks to have in your portfolio as it ensures sufficient enough diversification whilst also being manageable to keep track of.
3) INVEST IN DIFFERENT SECTORS
Owning 20 different stocks is not necessarily diverse. However, owning 20 different stocks across multiple sectors is. Investing in different sectors allows you to avoid being at the mercy of a particular sector if it's disrupted or impacted by innovation or regulation. It's very rare that all sectors crash at the same time so investing in different sectors should help your portfolio to retain relatively stable.
It's vital to make sure that you fully understand each sector that you invest in so you can successfully identify the most promising companies in that space.
4) DIFFERENT INDUSTRIES
If you decide that you want your portfolio to be heavily weighted to a couple of sectors that you understand and believe in such as technology and travel. It might then be wise to ensure that the stocks within these sectors have different focuses. For example if you have 10 technology stocks, try to make sure that all of them don’t do the same thing. Entire industries often get replaced due to innovation and you don’t want to put yourself at risk of this. Instead of investing in 5 stocks that sell video games, you would be safer investing in a 1 or 2 of the best video game companies and a couple within memory chip suppliers, ecommerce and artificial intelligence.
5) GEOGRAPHIC DIVERSIFICATION
If you only own stocks that operate in a single market like the US or Europe, you will be exposed to the political and recessionary prospects of that single region. This doesn't mean that you should be researching foreign stocks and investing in markets that you know very little about as many large European or American companies have done diversifying of their own and have huge overseas exposure. Instead, try and choose one or two stocks that are global or well diversified to ensure protection from a specific area slipping in to a recession or worse.
6) COMPANY SIZE
These days with numerous ETF’s and indexes that focus on a particular group of stocks, it is more common than ever that companies of a similar size or in a similar sector will rise and fall together. As a result, it is important to own a mixture of small and large cap stocks (small and large companies).
Remember: Large cap stocks are more seasoned and will carry less risk. Small cap stocks on the other hand are considered more risky but offer a greater chance of big returns as they have a lot of room to grow.
7) INVESTMENT STYLE
There are 3 key investment styles: 1. Growth, 2. Value and 3. Index investing. As mentioned above, index's carry the least risk as they involve spreading your investment across hundreds of stocks. Value stocks are stocks that are cheap on a price to earnings ratio and are usually trusted large cap businesses (such as Disney) that don't carry too much risk due to their track record and size advantage over their competition.
Lastly, growth stocks are stocks that are still focused on growing their revenue and reputation such as Video conferencing company Zoom. They are more risky to invest in as they often focus on disruptive sectors. However, they are usually fast growing businesses that have the potential to grow into much larger companies and therefore the potential to double your investment is a lot greater!
Each of these three investment styles falls in and out of favour with the market depending on the economy, interest rates and consumer spending so it’s a good idea to have a combination of all three.
8) DOLLAR COST AVERAGING
So by now you should have a portfolio that at least comprises of numerous individual stocks across various industries and/or sectors. Now you could further diversify each individual investment by opening multiple smaller positions in each of them as opposed to one lump sum investments... I'm aware that this is beginning to sound like inception for trading. The practice of only investing part of your entire amount initially and then gradually adding to your positions on a regular basis is called dollar cost averaging and this gives you more protection in case the market were to suddenly drop soon after you started investing.
Rebalancing is often a forgotten method of ensuring proper portfolio diversification. It's important to realise that when some of your individual investments grow faster than others, your portfolio may have skewed to become more heavily dependent on the best performers. Therefore it's important to reinvest the gains that you're making not only to take advantage of compound interest but also to keep your portfolio from becoming too heavily exposed to one or two particular stocks.
I suggest rebalancing your portfolio a couple of times each year (more than that and you risk not giving your investments the time they need to work for you). Additionally, you may wish to change your diversification around based on changes to particular economies or maybe you have identified a new industry that you believe has huge growth potential and wish to add this to your portfolio.
Lastly, remember to always keep a bit of cash available by trimming your best performing investments. By having a little bit of cash available then you will be able to capitalise on falling stock prices during any economic downturn or financial crisis. Also, if a lot of your wealth becomes tied to your stock portfolio then it's good to have some cash on hand to provide you with some assurance as your stocks begin to lose value.
In summary, a diversified portfolio is necessary to increase your chances of higher returns whilst reducing your risk. However, with more risk comes more reward and there is such a thing as over diversification. Remember, the more you research and understand the stocks that you own, the less you need to diversify and dilute your best trade ideas.
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