A Strategic Requirement: Diversification

The idea behind diversification is that it does not make sense to place all of your capital in one place. The risk is too great. So you spread risks by selecting different stocks or other products, so that no single economic, cyclical, or market event or news will disrupt your entire portfolio.

The methods of diversification are many. Best known among these is spreading risk by selecting different stocks. As a basic form of diversification, this move makes sense. Owning three stocks with equal dollar values in each, rather than placing all of your cash into a single stock, means that a decline in value of any one only affects one-third of the total.

The Risk of Ineffective Diversification

This may not be enough diversification, however.
If all three stocks are in the same industry, a change in the economy affecting that industry is also likely to affect all three stocks. Industries tend to share the same business cycles and to react to economic news (unemployment, interest rates, currency values) in a similar manner.

Key Point

Owning several stocks subject to the same kinds of market risks is not diversification; it is simply living with the same risks in different stocks.

Even different industries may react to the same economic news in the same manner. So simply holding several different stocks might still expose you to market risk. For example, if you hold stock in three companies, all of which do the majority of their business overseas, how will currency exchange trends affect value? If all of your companies rely on borrowing money to fund operations, how will rising interest rates impact stock prices?

To truly diversify among different companies, your holdings should be among companies that do not share the same vulnerability, especially to factors likely to hit the stock price in a negative way. For example, if you buy shares in companies in different industries but all are technology stocks, any factors hurting stock prices are likely to lead to declines in the value of your entire portfolio.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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