One of the most important principles in investing is to maintain a diversified portfolio. This means having a mix of stocks in different industries and sectors, to limit exposure to any single stock or risk factor. Diversification is most often measured by analyzing the correlation of stocks.
Investors can either diversify on their own, or by mixing individual stocks with exchange-traded funds (ETFs). Diversification reduces portfolio risk by lowering exposure to single company headwinds and cyclical market trends. It’s also important to consider exposure to currencies, commodities, and regions. The drawback is that it can limit short-term gains and be time-consuming to design.
ETFs are a popular choice for diversification because they offer a way to get exposure to multiple quality assets in a single investment. For example, an ETF that tracks the US clean energy sector gives you broad exposure to the largest players in the market. This can be a good way to diversify your portfolio without having to buy and manage individual stocks.
ETFs are subject to market volatility and fluctuations in the value of the underlying assets and they are not without their own risks. The composition must be considered. A tech ETF with a significant holding in AAPL, does not reduce the risk of a portfolio heavy in AAPL stock, it does the exact opposite. In such a case a pharmaceutical ETF might be more appropriate.
Also consider any correlations, like the relationship between retail and banks. Even though they can help you diversify your portfolio, they are not a guarantee against losses.
Here are some factors to consider when diversifying a stock portfolio:
- Asset allocation. Consider your balance between different asset classes, such as stocks, bonds, and cash. You don’t always need to be fully invested, especially in poorly performing assets or markets. Can you buy it for a lower price later, if you wait?
- Industry: Consider investing in stocks of companies in different sectors, such as technology, green energy, healthcare, and finance. This can help to reduce the impact of economic downturns in specific sectors on your portfolio.
- Company size: Diversifying by market capitalization means investing in stocks of companies of different sizes, large, medium, and small. They are in different growth phases. A $100 billion company will likely not yield 10x return in the near term, but can be a great source of less volatile stable growth.
- Investment style: Consider how the company matches your expectations of risks and returns. Some seek slow stable growth by bonds or high dividend stocks. On the other hand, some tech and pharma stocks offer extreme growth, but at extreme risk. Take the time to find the right balance for you and pay attention to details like debt and low/high insider ownership.
- Geography: Consider different countries or regions. This can help to reduce the impact of currency, political and economic events. Exposure to other economies can provide both a source of growth while also being a hedge for movements in your local market.
There is no one-size-fits-all solution. The best approach for you will depend on your investment goals, time horizon, and risk tolerance.
Start with researching the stocks that interest you. Then, based on your choices, broaden your portfolio composition to other factors mentioned above. Consider using one of the many online robo-advisor tools like Betterment and Wealthfront to help you. Once you’ve narrowed down your list of stocks, ETFs or others, you are off to a good start.
Here is where most investment advice ends!
You’ve built a great diversified portfolio and hopefully your work is being rewarded. Time to focus on more fun things….
Now comes the “holding” phase where your expectations and the markets hopefully find each other.
Your analysis and choices are snapshot in time. The economy, markets, laws and companies change, opportunities arise rise and fade. The environment around your savings is in constant motion.
With a diversified portfolio time is your friend, but no investor is perfect. No investor can predict the future.
Buy and hold, does not mean buy and ignore. The single biggest threat to your investments is your attention.
You will need to adjust your investments and hopefully add to your investments.
Make it a habit to track your investments. The prices and profit/loss alone will not tell you if your case for investing still holds. Be unconditionally honest with yourself.
Following the news, commentary and analysis for a list of stocks is prohibitively time consuming for most people. That is why we built StockHawk, a service that makes it easy to follow your portfolio in a few minutes a day.
The most important part is to make it a habit.