Diversification - Eggs In A Basket

Diversification means spreading your risk. The old adage of not putting all your eggs in one basket has considerable merit in designing a good investment portfolio.

Don’t put all your faith in one company or in one industry, because it may disappoint you. If you buy a diversified group of fundamentally sound stocks with good earnings and growth, the chances are that in a good market you will catch at least some of the winners, since most big money in a diversified portfolio comes from one or two big winners.

NON-DIVERSIFIED

Investing in a Single Source

DIVERSIFIED

Spreading Out Your Investments

There are two benefits to diversification. First, it reduces the volatility in the value of your portfolio. When one of your holdings is down, odds are that others are up. This stabilizes your portfolio performance. Secondly, diversification allows you to obtain a higher rate of return for a given level of risk.

Don’t be deceived into thinking that eight airline stocks or eight computer stocks represents diversification. They do not. You should strive for a portfolio covering a wider range of industries. For example, you may have some stocks in the health care industry, the retail area, automotive, beverage, telecommunications, electronics, and others.

Now don’t over diversify, because you may find that you are unable to manage a large number of companies. If you limit your holdings to ten stocks and a stock comes to your attention that you feel you should buy, what will this force you to do? Probably eliminate one.

In order to move to strength, it would now be prudent to go through your list and sell the one that is doing the poorest job. The way to upgrade a portfolio is to sell your losers and keep your winners, as this allows you the possibility of continuously moving to a position of strength.

When managing your portfolio, you may find it extremely helpful to utilize mutual funds. A mutual fund generally has anywhere from 20 holdings to as many as 500, usually from a wide spectrum of industry groups.

By purchasing a mutual fund, you will find that it will help your portfolio become more diversified. Diversification such as this can permit you to own your slice of the U.S. economy by becoming a part owner of the major companies whose products and services you use regularly.

When researching mutual funds, remember to look at the industry sector weightings. Many popular mutual funds may have a high percentage in a certain industry, for instance technology. If you design a portfolio with several mutual funds, be careful that your overall portfolio is not weighted too heavily in one industry.

One final point: make sure the mutual funds in your portfolio have a low over-lap ratio (correlation). A portfolio with many mutual funds and a high overlap is not diversified. For example at one time in 1999 Janus Funds had four mutual funds with very high correlations. So if an investor owned two or more of them it did not help diversify their portfolio.

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