Everystock investor has heard about the importance
In fact, I have emphasized many times in my articles just how
critical being properly diversified is when managing a successful
long-term portfolio. Diversification is not just critical for a
long-term portfolio -- it is the primary key for survival in the
Massive bull markets, like the one taking place now, can have
the negative effect of causing investors to become complacent,
take too many risks, and not diversify correctly.
I know from experience that it is difficult not to go "all-in"
on a hot stock. During the dot-com boom of the late 1990s, one
Internet stock in particular just seemed to be going up day after
Noticing the uptrend, I decided toliquidate my portfolio and
go all-in with this stock. Ignoring everything I knew about
diversification, I used all of mycapital andleverage , purchasing
a large number of theoutstanding shares .
As you may expect, Murphy's law was in full force, and the bad
news hit the newswire on my second day of ownership. The stock
that had climbed day after day, week after week and month after
month suddenly took a nosedive. By the time I could dump
theshares , I had lost about a quarter of the hard-earnedmoney in
Had I remained diversified and only purchased a sensible
number of shares, the damage to my meager account would have been
Despite hearing about it all the time, many investors don't
know what diversification is or how to properly diversify a
portfolio. Let's begin with a definition.
"Diversification is a method of
whereby an investor reduces the volatility (and thus risk) of his
or her portfolio by holding a variety of different
that have low correlations with each other," according to
Remember, smart investing is a trade-off between risk and return.
It isn't an all-in gamble on a single stock. Think of
diversification of a way of spreading risk.
Diversification is a personal choice based your needs, goals
and time frame. My personal rule of thumb is tooffset orhedge
each risky position with something considered more stable, if
Clearly, this 1-to-1 level ofhedging isn't for everyone. I
don't always stick to the rule, but it provides a basic framework
for building a diversified portfolio.
With this in mind, here are four guidelines for
1. Diversify Between Asset Classes
Asset classes are different types of investments.
) allow investors to diversify across asset classes without
having to step outside of a regular stock brokerage account.
The primary asset classes includeequities ,bonds ,
commodities, currencies andreal estate . Building a portfolio
that comprises each of these is one way to diversify. For
example, if you are concerned about structural risk, rather than
purchasing real-estateinvestment trusts (REITs) through your
brokerage account, you could purchase actual investment
The same goes for precious metals and other investments. If
you are worried about the integrity of the stock market or
individual brokerages, buying the physical counterpart makes good
sense as a diversification tool.
2. Diversify Across Securities Within EachAsset
This means to invest in mutual funds, ETFs, managed funds and
individual equities within each of the primary asset classes.
An example would be to own
SPDR Gold Trust Shares (
, a mining companyETF , as well as a gold-basedmutual fund . As
stated above, hard-core diversification would include the
physical metal, as well.
3. Diversify Across Fund Families And Money
This strategy mitigates management risk.
In today's environment, the risk of internal fraud, negligence
or mismanagement runs high. This is why investing into several
differentfund families and money managerswill help prevent you
from being wiped out should one of the management companies have
unexpected financial problems.
Bear in mind that this does not protect you from a structural
breakdown of the financial marketplace. If this occurs, we will
all have greater worries than our stock portfolios. That said,
physical assets such as real estate and precious metals could
mitigate losses in true economic disaster-type situations.
4. Diversify Across Time
This is one of the most powerful yet least understood methods of
diversification. Buying into a stock across time rather than all
at once is a smart move in most market conditions.
The one time it doesn't make sense is during times like now,
when a roaringbull market would create larger returns if all the
capital had been invested all at once rather than over time.
But unfortunately, the good times are only observable in
hindsight. Therefore, "woulda, coulda, shoulda" reasoning does
not negate the importance of diversifying across time with your
No one can time the market exactly.Investing on a regularbasis
, rather than all at once, can result in larger and safer
Risks to Consider:
Proper diversification mitigates risk rather than increasing
it. Obviously, spreading out risk will lessen your
portfolio'supside , but the benefits far outweigh the
possiblegains over time.
Action to Take -->
The first step is to review your portfolio to assure that it is
properly diversified for your needs. Using the ideas above is a
good way to start.