What professional money managers know and private investors need to learn is how to avoid depending on chance to determine their investment results. One of the first principles is to reduce risk by diversifying ─ spreading risk over a number of different stocks. Since over the long term even the best stocks fluctuate in value, the goal is both to avoid catastrophic losses as well as smooth out the ups and downs of your total portfolio value by always having some stocks that are outperforming others.
Almost instinctively, everyone knows this. But in practice, that notion only takes you so far. What you really need to know is this: how many different baskets are there, and how many do you need to potentially achieve the best result?
In no particular order, here are the keys to effective risk control of a stock portfolio through diversification:
Number of stocks. There is no preferred number of stocks that provides just the right amount of diversification. But most money managers agree that it falls in the range of 10 to 30 isn’t enough. The underlying trade-off is safety versus performance. The more stock issues you own, the lower your risk; but at the same time, the lower your potential return, as the results of the best performers get diluted by the other stocks.
Weighting. To diversify properly means you have to pay attention not just to the number of issues you own, but how much money you have invested in each. If you have 10 issues, but 90% of your money in one; you’re not properly diversified. The more evenly you spread your money among the stocks you own, the more diversified your portfolio becomes.
Sectors and industries. Similarly, you’re not very diversified if all of your stocks are in the same sector of the economy. While you may be hedged against the risk of severe mismanagement at any one company; in general, stocks in the same industry move in roughly the same direction at the same time, because they’re all exposed to the same risks in their marketplace. You achieve more risk control by choosing stocks from at least five sectors and, within sectors, different industries.
Company size. When it comes to stock performance, size matters. Size is measured by the stock’s price times the number of outstanding shares, for a figure called market capitalization, or market cap for short. In general, over the long run, small-cap stocks produce the best returns, followed by mid-size stocks, and then large-cap stocks. As you might expect, among these three categories, small-cap stocks are the riskiest and large-cap stocks less risky and more stable. Having all three in your portfolio offers another level of diversification.
Investment style. There are two classic investment styles: growth and value. Studies show that over the long run they generate roughly the same total return. One difference is a matter of volatility: growth stocks tend to have wider swings in value, both up and down, than value stocks. Another is timing. Normally, they take turns outperforming each other. By investing in both at the same time, you increase your diversification benefits.
Domestic and foreign. Finally, you can diversify by where your stocks operate, since foreign markets are often out of phase with the U.S. market. Among U.S. – traded stocks, you can obtain more diversification by investing both in companies that operate only in the U.S. as well as in multinationals. You can also invest in foreign-based companies whose stocks trade in the U.S.
Clearly, it takes careful research and analysis to create and maintain a properly diversified stock portfolio, and there are many ways to do it. Most important, however, is to build a portfolio that can meet your goals while suiting your tolerance for risk. It’s possible both to over – and under-diversify. Keep in mind that diversification does not guarantee profit or protect against loss in declining markets. Please call if you’d like to discuss this in more detail.
Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.