For the average person, the concept of diversification is a must in every portfolio. In it’s purest form, you are managing your risk. Why diversify your investments?
Diversification, as defined in Merriam-Webster’s dictionary, is to balance (as an investment portfolio) defensively by dividing funds among securities of different industries or of different classes.
The reason this is important is because industries do not move in a synchronized way. As I learned in Jim Cramer’s book, Real Money, certain companies thrive when the economies are growing while others do better when the economy is shrinking.
That being said, it would be smart to have your money allocated equally among several different industries in order to manage the risk of economic fluctuations.
If the facts are showing the economy is heading into a downturn, it wouldn’t be smart to have all your money in the technology companies, since much of this spending is not a household necessity. Conversely, it’s probably wise to assume companies like Johnson and Johnson or WalMart would be a safe place to park your money in rocky times.
While most of us don’t have enough time to track the financial markets every ebb and flow, diversification is a way to keep your portfolio in the best position for long term growth, no matter what happens. As the great Tony Robbins writes in his book, Money: Master the Game, it’s all about asset allocation.
How Do You Diversify Your Investments?
Let’s say you have $10,000. A simple example of diversification is to divide $10,000 into 5 different mainstream industries. We’ll go with Technology, Financials, Energy, Utilities, and Healthcare. The odds are overwhelmingly in favor of these five industries not moving in the same direction.
If Tech is hot, financials may not be, this will bring stability to your portfolio as the fact is that they won’t all tank at the same time, if it all decides to hit the fan. Whether you put $2,000 into one stock per industry or choose another number, it will be up to you. As long as your allocation is equal among each group, you will be considered “diversified.”
Another way to do this is to use exchange traded funds or index funds. Rather than picking an individual stock, why not pick them all?
These type of financial instruments will allow you to mirror the returns of a whole industry or exchange. Personally, I am a fan of the SPY, which mimics the movement of the S&P 500.
It’s also recommended by many to include foreign markets as part of your strategy. Who’s to say America the only place to park your investments. If I remember correctly, international funds were the place to be when things were not looking so good around 2008.
Don’t alienate natural resources like Gold. The age old advice is to have 10% in your portfolio at any given time. This is because Gold has an inverse correlation to the performance of the economy, more specifically the US dollar. If things are going South, get some Gold!
You can diversify your industries, as well as your locations. Though some may disagree, rarely can you over-diversify.
Even so, many more advanced strategies exist. They involve the use of options, CFD’s, and Forward Contracts. All viable options, especially when guarding against currency risk. These type of investment vehicles are ideal for those considering international transactions. For instance, options are widely used to hedge investments. If you’ve taken a position in one asset, you can hedge your bet by counterbalancing it with a position you believe will mitigate your risk.
Currency Risk, as defined in InvestingAnswers.com, is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or in foreign-currency-traded investments. If you use services like the ones you can find on this website you can mitigate that exposure.
Is Diversification for Dummies?
Warren Buffett, aka the Oracle of Omaha, is one of the most successful investors of all time. He has stated that “diversification is protection against ignorance, it makes little sense if you know what you are doing.”
How could this be? Is the Michael Jordan of investing disagreeing with the conventional wisdom seldom challenged?
He believes you are leaving money on the table if you are an investor trained in spotting trends in stock and company performance. I take it that in his view, professionals are monitoring their positions with specialized knowledge. They will be able to get in or out of a position based on their indicators.
The average investor won’t be able to do that. The age old buy and hold strategy will be best employed through diversification. If you aren’t a trained investor who is working full time, it wouldn’t be wise to make a couple big bets on some positions you are “comfortable” with.