Diversification is one of the most important aspects of a successful portfolio, which is a golden rule for investors. It means accumulating a variety of stocks from different markets, sectors, and market capitalization sizes. This helps reduce your investment’s exposure to market volatility.
In the event of a market downturn, it is much safer to invest in several different companies from different sectors and different sizes than to stick to just one group of stocks. Many people lost everything during the dot-com crash of the late nineties. Diversification can help investors avoid a similar fate.
Since some investments go up in value while others go down, the main reason diversification is important is that it tends to reduce the overall risk in an investor’s portfolio. This can help an investor take on risky assets without risking being wiped out when they go down in value.
Suppose you have two stocks in your portfolio. If they go up, they are highly correlated. When one goes down, the other will hurt the investor. However, if an investor picks two stocks that are not correlated, then when one goes up, the other will go down.
An example of the problems inherent in owning a concentrated portfolio occurred in the technology sector in the early 2000s. In the late 1990s, investing exclusively in technology stocks seemed like a smart strategy.
However, when the tech sector eventually crashed in 2000, many investors who held large amounts of these stocks saw their portfolios plummet by 80% or more. It took many of these investors years to recover from these horrific losses. By comparison, most investors who held a diversified basket of stocks (representing tech and a variety of other sectors) managed to hold up quite well during the tech downturn.
How Many Stocks Do You Need for a Balanced Portfolio?
Diversification is perhaps one of the oldest and most important concepts in the entire investing world. The basic idea is to invest in a wide variety of assets in order to minimize risk.
There is no single answer. A portfolio consisting of a group of 20 or 30 stocks spread across different sectors should provide adequate diversification for a stock portfolio. In comparison, a portfolio of 5-10 stocks is likely to be much more volatile.
The minimum number of stocks a healthy portfolio should have is 12. It’s important to understand that this doesn’t mean you should just go out and invest in the top 12 companies on the list and hope for success. There’s more to it.
You should also spread your portfolio across several different sectors. This could be anything from technology to restaurants to travel. This is an important part of diversification because it allows you to spread out and manage risk.
Diversification, while not a guarantee against losses, is the most important component of achieving long-term financial goals while minimizing risk.
In other words, you will always have stocks in your portfolio that may not do well, but in the long run, it won’t matter compared to the winners.
There are many different ways to diversify a portfolio, but the basic idea is to invest in a diverse set of asset classes (such as stocks, bonds, cash, and real estate—even collectibles and precious metals) and then invest in a diverse set of assets within those classes.
For example, an investor with a long investment horizon might decide to invest 80% of their portfolio assets in stocks, 10% in fixed income, and 10% in cash. In contrast, an investor with a shorter time horizon might decide to be a little more cautious. They might allocate 60% to stocks, 30% to bonds, and 10% to cash.
Another method of diversification involves allocating a certain percentage of your portfolio to different investment categories within each asset class. For example, an aggressive investor might decide to allocate 80% of their investments to growth stocks and 20% to high-dividend stocks.
No portfolio is perfectly diversified because different investors need different types of diversification. For example, younger investors may be better off investing a larger portion of their portfolio in riskier assets than older investors. Therefore, their decisions about portfolio diversification will be different.
The type of company you invest in will depend on what you expect from your investment. Are you hoping to earn a steady income for retirement, or are you looking for income right now? Remember that patience is the key to long-term wealth in investing.
Peter Lynch, one of the greatest investors of our time, classified stocks in 6 ways, depending on what industry they are in and what you as an investor should expect in terms of returns:
Slow-Growers: Usually large companies, they grow slowly during times of abundance, but also fall slowly during downturns.
Resilient: Remain stable in the most difficult market conditions because people always want what they offer.
Fast-Growers: Smaller, younger companies that have a big impact on the market and are constantly increasing their revenue.
Cyclical: Companies whose profits and sales rise and fall at regular intervals, such as airline stocks.
Turnaround: Companies that are struggling but could potentially turn things around with some smart moves.
Asset plays: Companies whose assets may not be reflected in their bottom line.
For beginning investors, it’s always a good idea to stock up on growth, resilient, and fast-growing companies. It’s always a little safer to invest in slow-growing, resilient stocks, which tend to be the best representation of the overall market. And so far, since its inception, the market has averaged 10% per year over a ten-year period.
However, as you begin to gain more confidence in your investment portfolio, you may be able to venture into riskier investments.
