The Importance of Diversification

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In a recent post I talked about the 5 “buy” signs for a stock. However, your portfolio should never consist of just one stock, Exchange Traded Fund (ETF) or mutual fund in the long term because of the potential exposure to loss you will have. So to manage your risk, you must diversify your portfolio. A good rule to remember is that “The more diversified you are, the less pain your portfolio will feel in the long run”

Another reason to diversify is that it is possible to have too much of a good thing. That’s especially true when strong performance in a particular market sector causes one part of your investment portfolio to bulge while other parts shrink or grow only modestly. In such situations, instinct may tell you to celebrate your good fortune and leave your portfolio as is—or even to load up on the investment that’s doing well. But, in most cases a smarter approach is to take a close look at your long-term investment strategy and take steps to restore your portfolio’s diversification.

Protect yourself by learning from the past

Many investors don’t want to worry about diversification when they’re enjoying a stock market run-up, such as the one we saw in the first half of 2007. But letting one part of your holdings swell disproportionately can be risky. This would have clearly been felt with the market downturn in 2008 where financial stocks, disproportionately large in a number of investment portfolios, meant that a lot of amateur and professional investors took big losses. Conversely, if you had a well diversified portfolio, you probably held up better than most.

A key investment lesson of the last decade is that no one type of investment should have too much—or too little—weight in your portfolio. For many investors, the harm caused by the collapse of technology, financial and telecommunication stocks was compounded by a lack of portfolio diversification.

Of course, investment diversification will never eliminate your risk of loss, nor will it guarantee a profit in a declining market. But it should reduce the chance that you’ll suffer disproportionate losses if one particular high-flying sector suddenly descends to earth. And owning a portfolio with exposure to all key market components should give you at least some participation in whatever sectors are performing best at a given time.

Don’t lose your balance

Once you’ve established a diversified portfolio, you’ll have to make sure you don’t lose the balance you’ve worked to create. That will mean periodic re-balancing—shifting money from one type of investment to another—to ensure that you continue to hold the mix of stock, bond, and short-term investments that you deem appropriate for yourself.

Re-balancing will result in taking some money away from the top performer of the moment. While that can be emotionally difficult, such investment discipline will help prevent you from becoming too heavily weighted in one area. Investors, of course, want to buy low and sell high, and that is what re-balancing can help you do.

I consider having a well diversified portfolio as an integral part of my investment strategy. To enable this I track my investment performance in a simple Excel spreadsheet, where I also track what percentage (%) of my total portfolio each stock, ETF or Mutual fund makes up. Every 3 months, I evaluate my portfolio and if a particular investment makes up more than 20%, I put a plan in place to reduce it (and hopefully take some profits) to between 10 – 15%. This also enables me to convert paper profits to real profits – a good habit for successful investors.

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