The Importance of Diversification When Building a Stock Portfolio

Everyone knows that the golden rule in building a stock portfolio is diversification. It’s common sense really, and just a modern variation of that old saying: “Don’t put all your eggs in one basket.”

Given that it’s universally agreed that a healthy portfolio is balanced, varied, and diverse, how does one go about building up the ideal basket of mixed assets? This basket should be a mixture of high, low, and medium-risk properties across a wide range of sectors, with stocks and bonds balanced by a safety net of cash savings. There are many factors to consider when deciding exactly what mix is best for you, including your age, temperament, and the extent to which you rely on your investments financially. However, a few basic principles also apply across the board, as we shall see.

stock portfolio in one basket.
Don’t put all your stock portfolio eggs in one basket.

Playing Smart

We’ve mentioned how a strong portfolio balances stocks, bonds, and cash, but there should be diversification within these categories, too. Stocks should balance domestic against international companies, drawing in the latter case on both established and emerging markets. A smart investor also puts their money into a range of different industries so that if, for example, the price of steel drops, they can fall back on their oil investments or vice versa. It has been said that in today’s global economy, diversifying across sectors is not as failsafe a way to protect your portfolio as it once was, but while this is true to an extent, it is still good practice to follow, so long as one doesn’t become complacent as a result.

Starting Out

For beginners, a mutual fund or exchange traded fund (ETF) can be a great way to start investing. As little as $50 a month can buy an investment in a ready-diversified portfolio. Anyone doing this, however, should make sure that the aims and purposes of the mutual fund tally up with their own investment objectives.

It’s always a good idea to get professional financial advice from a specialist, especially if you have little or no knowledge of how the market operates. Even those with considerable financial literacy can benefit from expert help. Successful investors, such as Ken Fisher, have made a lifelong study of how the financial markets work, and anyone can benefit from their advice. Fisher, in particular, has shared his knowledge in a range of books and other media, and these are a great place to start for anyone hoping to become a successful investor. Many professionals will, of course, offer personal guidance or portfolio management for a fee, and this is often well worth doing.

Long-Term Planning

Stocks in smaller companies with great growth potential also hold more risk of failing, so balance these with equity in large, stable firms where the value probably won’t vary too much from year to year. A varied selection of bonds is also a good idea, with government bonds as well as corporate ones, and some from outside the US as well as from within. Be aware that different bonds may have different ratings and maturities. Low-rating bonds or those that won’t mature for ten years or more tend to pay more interest, but older investors might want to consider whether they are prepared to wait for these bonds to pay out.

On this note, the general balance of any portfolio should shift over time. A majority of high-risk equities makes sense for an investor in their twenties who is prepared to play the long game, but as the years go by, they should gradually rebalance in favor of more stable, conservative investments. This way, as they approach retirement, they’ve got a nest egg mainly composed of safe, solid assets that are less likely to lose value dramatically just as they need to be cashed in.

Stay Protected

It’s always a good idea to do as much research as possible into a company before investing, and to keep abreast of their day-to-day activities, so long as their stocks remain part of a portfolio. This will help one to make the right choices and decisions, but every investor, no matter how experienced or well-prepared, will occasionally find that elements of their portfolio perform worse than they were expecting. In this situation, it’s essential to be able to accept that sometimes you will make the wrong decision or that the unexpected can happen.

No investor is infallible, but someone who cannot take the rough with the smooth is more likely to panic and sell up at the very worst moment. Happily, a well-diversified portfolio is the best protection against unexpected misfortune, and this applies whatever the size or value of your investments.

Luke Stone reports on business events and issues, including startups, fast-movers and companies to watch.