When you’re diversifying within your stock portfolio, there are two types of diversification to consider: horizontal and vertical.
- Horizontal diversification is holding stocks in, say, one industry. For example, you might own shares in a technology company index. Even though each company in the index faces similar market trends, each is also subject to unique strengths and weaknesses. Again, the principle of horizontal diversification is to mitigate risk. To use our example of the technology index, some of the companies in the index do poorly, but many of them do well ─ and your gains mitigate your losses.
- Vertical diversification involves choosing stocks across industries or markets. For example, you might own shares in a technology company, a furniture company, and an energy company (or better yet their respective indices). Mitigating risk is still your goal with vertical diversification.
The level of diversification you achieve depends in large part on the level of correlation of the companies or industries in which you invest. Correlation is a measure of how the stocks of two companies or industries move in relation to each other. Stocks that are highly positively correlated tend to move up at about the same pace. Some companies and industries are less correlated then others; as a general rule, the less correlated the better.
In general, the more broadly diversified your stock portfolio is ─ both horizontally and vertically ─ the better your balance between risk (losses) and reward (gains). If you’d like some help ensuring that your stock portfolio or investment portfolio in general is broadly diversified, please call.
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.