Diversification means spreading your risk among several products. The old adage of not putting all your eggs in one basket relates very well when it comes to designing a good investment portfolio.
Don’t put all your faith in one company or in one industry, because it may disappoint you. How many people believed Enron stock was a great investment for their retirement accounts? Not any more, they don't.
If you buy a diversified group of fundamentally sound stocks with good earnings and growth, the chances are that in a good market you will catch at least some of the winners, and in a down market, you won't be left holding all the losers.
There are two significatn benefits to diversification. First, it reduces the volatility in the value of your portfolio. When one of your holdings is down, odds are that others are up. This stabilizes your portfolio performance. Secondly, diversification allows you to obtain a higher rate of return for your level of risk.
Don’t be deceived into thinking that eight airline stocks or eight computer stocks represents diversification. They are all companies within a single industry. Strive for a portfolio covering a wider range of industries. For example, you may have some stocks in the health care industry, the retail area, automotive, beverage, telecommunications, electronics, and others.
Over diversification means you are unable to manage the large number of companies. If you limit your holdings to ten stocks and a stock comes to your attention that you feel you should buy, what will this force you to do? Probably eliminate one of the under achievers you are holding.
The way to upgrade a portfolio is to sell your losers and keep your winners, as this allows you the possibility of continuously moving to a position of strength. When managing your portfolio, you may find it helpful to utilize mutual funds. A mutual fund has anywhere from 20 holdings to as many as 500 from a wide spectrum of industry groups.
Purchasing a mutual fund will help your portfolio become more diversified. When researching mutual funds, remember to look at the industry sector weightings. By designing a portfolio with several mutual funds you will want to be careful that your overall portfolio is not weighted too heavily in one industry.
Roger Sorensen
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