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Diversification: A Great Idea, But Don’t Overcook

Diversification: A Great Idea, But Don’t Overcook

As investment strategies go, diversification is easy to love. Nobody has to convince you that variety is the spice of life, that you shouldn’t put all your eggs in one basket or that there’s safety in numbers.

But diversification isn’t easy to do well, especially when your goal is to achieve a long-term return on your stock portfolio that beats the overall market’s return. (Just so there’s no confusion, diversification, in the context of investing in stocks, means buying a number of securities that not only have the potential for strong performance individually but when combined also reduce risk without substantially reducing return.)
Here’s how diversification works: If you could buy only winners — stocks that never dropped in price or had their dividends cut — your results would always be better than the market. But in the real world, every stock has bad stretches, whether because management makes mistakes, a competitor brings out a superior product, the industry suffers a downturn or the overall market falters.
When building a diversified collection of stocks, the idea is to create a portfolio whose components are, to some extent, negatively correlated. This means the stocks react differently to changes in the economy so that some are providing a strong return while others are in the doldrums. This type of balance is possible if you buy individual securities that are spread widely enough across market sectors, geographic and political borders, and other differentiating qualities, such as market capitalization. (A word of caution: Diversification doesn’t guarantee a positive return or protect you in case of a market meltdown, though it can help as markets recover.)

Putting Diversification to Work

Diversifying doesn’t mean buying hundreds of stocks. As an individual investor or investment club, that’s cost-prohibitive. Another problem is that there’s no practical way to do the due diligence essential for selecting a large number of securities and tracking how well they’re meeting your expectations.
Perhaps the most compelling reason for limiting the number of stocks you purchase is that the more you own, the more likely you are to simply replicate market results. If that were your goal, it would be a lot easier to buy index funds. Instead, what you’re after is a mix of strong companies that together have the capacity to outperform the market.
So how many stocks do you need? It won’t surprise you to know that people disagree. Philip A. Fisher, one of the great investors in the United States, made the case that putting 20 percent of your portfolio in each of five outstanding companies whose products don’t overlap or compete with each other was sufficient. Arnold Bernhard, the founder of Value Line, suggested 15 or more across more than eight industries. On the other hand, if you research the subject, you’ll find some people who insist on a minimum of 60.
A consensus seems to be that you’re on the right track with a portfolio of between 16 and 18 stocks that you intend to buy and hold.

Assembling a Portfolio

Diversification is something you do over time, not overnight, as you create a new portfolio or modify one that isn’t meeting your goals. If you want the strategy to work, you’ll need to set some standards to help guide decisions not only on what and when to buy but also — equally important — when to sell.
One approach is to create an equally weighted portfolio of large-company stocks — including American Depositary Receipts (ADRs), which represent the stocks of foreign companies — across distinct sectors of the economy. The Global Industry Classification Standard, which was developed by MSCI and Standard & Poor’s, is a worldwide classification structure you may find helpful in establishing your parameters. GICS identifies 10 sectors, including energy, industrials, consumer products, health care, information technology and utilities, and divides them into 24 industry groups.
Another way to diversify is across company size, including small-, mid- and large-company stocks. One potential problem, of course, is that it tends to be much more difficult to find the research you need to make informed decisions about small and even midsized companies. Their prices also tend to be more volatile, and the issuers may be more vulnerable to market downturns.
However you diversify, you’re likely to find that putting the strategy to work adds valuable discipline to your investment decisions.

Virginia B. Morris is the Editorial Director for Lightbulb Press.

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