Diversification Dos And Don'ts

There are good ways and bad ways to diversify your portfolio. Yes, you shouldn’t put all your funds into one stock. But the types of other stocks you choose and the amount of stocks in your portfolio matters too. Below are just a few important dos and don’ts to help you diversify efficiently.

The Dos of Diversification

DO spread your investments across different sectors

You’ll find companies from many different industry sectors in the S&P 500. A big mistake that some amateur traders make when diversifying is choosing lots of stocks from one single sector. A common example of this is investing purely in tech stocks (such as Microsoft, Apple, Nvidia, Palantir and Alphabet). The tech sector might be booming right now, but what if there’s one day a calamity that affects the entire tech sector? Investing into a few stocks from other sectors such as healthcare, consumer goods and energy could protect you from a sector-specific downturn. Your tech stocks might lose value, but your healthcare stocks could stay strong. 

DO invest in international markets

Beyond the NYSE and Nasdaq are a range of international stock exchanges that can also be worth exploring. These include Euronext, The Shanghai Stock Exchange, The Tokyo Stock Exchange, The London Stock Exchange and The Saudi Exchange. While it’s comforting to stick to familiar waters, investing in stocks from other countries could offer an extra layer of security. If there’s a domestic downturn, your European stocks or Chinese stocks might just come to the rescue. Just remember that foreign exchanges are open at different times of the day, so you might have to get up earlier or stay up later if you want to buy stocks, sell stocks or monitor what’s going on. Investing in international stocks also does mean keeping up with international politics. For example, knowing what’s happening in China will give you a better idea as to where Chinese stocks are going. 

DO rebalance regularly

You should ideally aim to keep a similar amount of funds in each stock you invest in. It’s unwise to dedicate more than 20% of your funds to a single stock - if that stock crashes, that’s one fifth of your funds gone. Modern trading platforms often allow you to visualise your portfolio as a pie made up of different slices for each of your investments. You should try to keep all of these slices a similar size. If one slice is much bigger than the others, consider rebalancing your funds. Don’t let one company guzzle all the pie! If one slice of pie is leaner than the others, you can similarly invest more funds into it if it’s making a return, or sell it and invest the funds elsewhere if it’s making a loss. 

DO remember your investment goals

The types of stocks you invest should be dependent on your goal. Looking to build your funds quickly? Aim to invest predominantly in high growth stocks - although higher risk, they will grow the fastest. Want to build some savings for retirement? Put some money into more stable stocks from older companies that have consistently proven to make slow but steady returns in the past. That all said, it’s still worth sprinkling in a couple high-growth stocks into a long-term portfolio to add some excitement, just as it’s still worth adding a few dependable slow-growth stocks into a short-term portfolio to add some stability. 

The Don’ts of Diversification

DON’T invest in things you don’t understand

While it’s important to invest in a range of sectors, you should be careful of picking stocks from industries that you know little to nothing about. Investing in random stocks just because they’re on the rise is essentially gambling. While you don’t need to be an expert in every company you invest in, you should ideally take some time to see what products and services they provide to get a better idea of how their price is affected. Some of the strongest portfolios are often made up of stocks that traders know and love - this can give you a much more intuitive idea of when and when not to invest. 

DON’T over-diversify

Diversification is all about balance. While you don’t want to just invest everything into one or two stocks, spreading your funds over 100 stocks isn’t sensible either. Known as over-diversifying or di-worse-ification, investing in too many different stocks often results in paltry returns. It makes it much harder to keep track of all the different companies you’ve invested in. As a result, you’re less likely to immediately notice which stocks are rising in value and which are falling unless you’re spending an hour per day trawling through them. Try to build a portfolio that is diverse but small enough to manage. Many experts recommend 20 to 30 stocks. Ideally, you should be able to name them all when asked to recall them. 

DON’T overlook quality

You could make an argument that even 20 stocks is too much. In fact, one of the most famous investors of all time, Warren Buffet, has long used concentration risk as a strategy: all of Berkshire Hathaway’s returns come from just 12 companies. The reason Berkshire Hathaway has such strong returns year on year is because Buffet has always focused on quality over quantity. Each of the companies he invests in is strong and well established with a proven track record of making steady returns. He doesn’t take a punt on new companies and avoids companies that have a history of volatility (even if they’re currently soaring in value). Choosing high quality stocks typically involves doing research into companies and not just choosing trendy stocks. Look at how well the company has performed over the years and heed the advice of seasoned investors.

DON’T make it too mathematical

It’s possible to take diversification too seriously and spend too much time and effort getting the percentages just right. Yes, you should try to invest a similar amount into each company. But you don’t have to precisely divide your funds into each. Yes, you should invest in different sectors. But you don’t have to maintain an even amount of stocks in each sector. Yes, you should invest in international stocks. But you don’t have to invest an exact equal amount into each stock exchange. Unless you enjoy approaching stock trading with mathematical precision, too many calculations will likely just turn trading into a chore. Aim to divide things up a little more roughly and trust your gut as to where to put your money. This will make building a portfolio more enjoyable. You also won’t have to check in as regularly - unless trading is your job, there’s no need to be logging in every day and tweaking things.

Conclusion

By following these dos and don’t, you can create a diverse portfolio that is profitable and protected against various different risks. The key is to maintain balance in terms of how you divide your funds and the types of stocks you invest in. At the same time, don’t let it become overly calculated to the point that it feels like you’re following a formula as opposed to following your gut. 

This is a contributed post.