The basics concepts of diversification
Diversification is an important part of investing and a concept that you must understand to become a better investor. The reason is because diversification helps you produce better returns over the long term for two main reasons.
First, it protects you from downside risk in the event that one of your picks takes a price hit and declines in price. If all of your money was in just that one stock, your losses would be amplified instead of the overall impact being lessened from the protection of the other stocks in the portfolio.
First, it protects you from downside risk in the event that one of your picks takes a price hit and declines in price. If all of your money was in just that one stock, your losses would be amplified instead of the overall impact being lessened from the protection of the other stocks in the portfolio.
Second, diversification also helps you improve your overall portfolio gains for the exact opposite reason we just talked about. Sometimes one of your stocks will get hot and make new highs. While this could happen if you only owned one stock, it’s extremely rare to have such luck. Your odds are much better at hitting on one of these winners when you have several stocks in the game. This simply increases your odds.
So how should you think about diversification and what are the main areas to look at when you implement a diversification plan? Here are some tips to make sure that your portfolio is diversified and setup to help you succeed.
Location
It’s important to think about diversifying across borders. This helps insulate you against local market downturns that can impact your entire portfolio all at once. When you only own companies based in The United States and the S&P 500 crashes, your whole portfolio is sure to take a hit. This is simply because all of your stock picks are tied to that local stock market.
It’s better to pick more global companies or diversify across national borders. That way, not any one stock market crash will affect your whole portfolio.
Industry
It’s most important to invest in stocks of companies that operate in different industries or sectors. Even though you may have picked stocks of different companies, it will do you no good if they are all in the same industry. The same concept applies here. If an industry heads into a downward spiral, all of the stocks in your portfolio will also decline in price substantially. This defeats the purpose of diversification and negates the benefits it provides.
Recently, the mining industry in The United States has been hammered. Imagine what your portfolio returns would look like if you owned a basket of coal mining stocks!
Allocation
The last major part of diversification lies in asset allocation. It’s important to own enough stocks to properly diversify while not owning too many that your portfolio becomes too difficult to manage. Most of us have full time jobs and don’t have 8 hours a day to keep up with what is required to own 100 stocks.
A good rule of thumb is to shoot to house 8 to 15 different stocks within your portfolio at any given time. This is typically the right amount of stocks for average people to manage. For true day traders and fund managers, who have more time, this amount can be much higher.
Second, make sure to limit your total investment to 10% of your funds in any one of these holdings to make sure that not too much of your money is at stake in any one position. This will help your portfolio perform better over the long term.
Diversification is an important concept to learn and implement if you want to be a successful investor. By keeping your portfolio well diversified, you’ll soon see that your performance improves over the long term and it will also help you to sleep better at night.
How KINFO can help you create a well-diversified portfolio
Using KINFO you can view the contents of portfolios from many other professional investors, both hedge fund managers and private investors. By looking at the performance you can sort out the top performers and review how well diversified their portfolios are. Read more about how KINFO tracks top hedge funds or how you can follow top performing private investors
