TheStockAdvisor Advice

Diversification

In order to maximize the prospects of success when building a long term portfolio Diversification is a virtual necessity. Of course, this topic brings to mind several cliches that may be a bit hackneyed but are still appropriate. One is 'Donít Put All You Eggs In One Basket' and the other a related idea, 'Variety Is The Spice Of Life.'

The explosive growth of the mutual fund industry in recent years is a direct reflection of this effort to obtain diversification. Those just starting to build a portfolio may decide the amount of money they have available for investment is too small to effectively spread over a number of companies, so they chose to have a professional manager take responsibility for this in the form of a pooled fund that spreads the investment over a range of issues.

The benefits of diversification are many. First and foremost is the ability to spread risk over a variety of issues. If one selected company does not match expectations and the price of its shares stagnate or decline, one of the other investments may be having a stellar year and its share value is ascending. By having spread the investment over two different companies, the portfolio value remains stable.

Of course, the ideal situation would be to pick only winners and then there would not be any potential dilution of profit by owning a stock that under-performs. However, few have been blessed with clairvoyance so the choices are to risk it all on that '100% sure investment, that will double in price within six months,' or to adopt a dose of reality and hedge oneís bets by taking into consideration the possibility that there are no guarantees in life and maybe a bit of caution is in order.

As mentioned, many investors utilize mutual funds for precisely this reason. With thousands of funds to chose from the investor can select funds that invest in specific industries, foreign stocks, small cap stocks or large caps or anywhere it deems attractive. While this has distinct benefits to many investors, there are drawbacks. The funds may be too large to move quickly to take advantage of special situations or too many laggards may dilute the effect of certain successful investments. Additionally, market leadership may change and the particular fund being used may be falling out of favor. While many fund managers can accommodate changes into other funds that have different objectives, this may not always be possible or easily accomplished.

A self-directed portfolio allows the investor direct control over the decision making process for buying and selling stocks. Portfolio changes can be quickly accommodated through a reliable broker. However, the investor must be disciplined to avoid the temptation to put too much of his assets into high risk investments in the hope of 'a quick killing.'

Furthermore, to obtain the true benefits of diversification do not just select several companies in the same industry. Study the prospects for different industry groups and select some that are contra-cyclical to one another. Namely, if transportation stocks look attractive it may still be advisable to keep some money invested in oil company shares since a sudden rise in fuel prices would likely depress transportation companies, but would be bullish for the oil sector.

It is, however, not necessary or beneficial to select only investments that are so decidedly opposite since performance of one might negate that of the other. The idea is achieve balance in the portfolio so that it can grow, or at least protect the investments, even during changing economic conditions.

In larger portfolios, balance can also extend to investments in certain industry groups, such as technology companies. While it may not be advisable to invest only in technology shares, one should consider investments in different segments of the industry. A computer manufacturer, a chip producer and a software developer may all be in the same broad category, but could have significantly different potential.

Many companies now have programs that allow for reinvestment of dividends into additional shares and small amounts of stock can be bought on a regular basis by joining various programs, either directly through company sponsored programs or by setting up monthly investment plans. Another options for small investors who wish to build a portfolio over time is to join an investment club. These usually consist of a small group of like-minded individuals who meet regularly to research possible investments and to pool given amounts on a regular basis.

There are many ways to achieve diversification. How you get there is less important than the fact you arrive. Because one should remember, 'donít count your chickens before they hatch'.


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