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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 "Don’t 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 one’s 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, "don’t
count your chickens before they hatch".
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