A Strategic Requirement: Diversification
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 DiversificationThis may not be enough diversification, however.
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?
Key PointOwning several stocks subject to the same kinds of market risks is not diversification; it is simply living with the same risks in different stocks.
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