Most people are aware that diversification is an important part of managing risk when putting together a portfolio. If you have all your money in one stock and it drops twenty percent, so does your overall account value. If, on the other hand, that stock is one of many that you own, the effect is lessened. Real diversification is not as simple as just owning multiple stocks, however. There are other factors that should be considered.
Market Capitalization: Market capitalization, usually shortened to market cap, is a measure of the size of the company issuing the stock and is calculated by multiplying the number of shares in circulation by the price of each share. Stocks are usually divided into small, mid and large cap, although you will sometimes hear about micro and mega caps as well.
In general, stock in smaller companies is riskier, but offers the prospect of better returns. Even giants like Apple (AAPL) and Google (GOOG) were small at one time and obviously getting in early on something like that can give a big boost to your account over time, but smaller companies are also more vulnerable to economic downturns. Having both small and large companies in your portfolio can reduce volatility when compared to all small caps, but offers better returns in the good times than owning all big companies with limited opportunities to grow much more.
Industry and Sector: As the economy changes and progresses, so the fortunes of companies in different sectors and industries shift. In 2016, for example, retail stocks generally suffered, while the computer chip and memory stocks, after a year or two of big declines, outperformed the broader market massively. Over time, stocks as a whole tend to go up in value, but that is not necessarily true of every sector.
In this case, diversification is all about limiting risk. It is impossible to predict with any accuracy which sectors of the economy will be hurt by or benefit from changes in fashion, habits and technology in the future, and even what look like safe bets now can quickly turn sour. Those who sunk all their money into real estate in 2006 and 2007 found that out the hard way!
A well-diversified stock portfolio would include exposure to most or all of the following: technology, traditional manufacturing, consumer goods, financials, energy, defense, utilities and healthcare.
Geography: This is the area of diversification that most tends to get overlooked by newcomers to the stock market, yet is in many ways the most important. The U.S. is a massive economy and leads the world in many ways, but still only accounted for less than a quarter of the world’s economic activity in 2016. In addition, growth varies enormously by country and so therefore, does stock market performance.
As with market cap diversification, geographical diversification can both limit risk and increase returns. There are some problems with researching and even buying international stocks, however, so the best way to achieve diversification in this case, even for those who prefer to manage their own account, is through an ETF that tracks an international index. Something like Vanguard’s International Ex-US Fund (VEU) would do the job.
True diversification is, as I said, not as simple as it may seem at first. There are many types of risk that need to be spread if you are to do it properly. It takes some effort, but anything that helps reduce the bumps along the road of stock investing is worthwhile.