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We already mentioned a diversified stock portfolio.
‘Don’t put all your eggs in the same basket’ is probably the best-known proverb advising investors about the importance of portfolio diversification to spread and reduce risk.
The major advantage of the diversified stock portfolio is its ability to protect your entire portfolio from the volatility associated with different asset classes.
In this article, we look at ways to protect your portfolio by spreading your risk across several different asset classes. Also, some of the many different assets in which you can invest, each with different risk characteristics.
Where is the advantage of the diversified stock portfolio?
The risks attributable to assets cannot be avoided. But when they are managed collectively, as part of a diversified portfolio, they can be diluted. Individual assets have a bearing on the overall level of risk you are exposed to.
And the correlation between the assets has an even greater bearing. This article considers how a well-constructed investment portfolio should be diversified in a variety of ways. Including overall investment style, a number of individual asset classes, the spread of geographical allocation and the approach of the fund manager.
The key is to build a diversified stock portfolio with a mix of different investments that make sense for your attitude to risk.
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A balanced investment portfolio will contain a mix of equities (shares in companies), government and corporate bonds (loans to governments or companies), property, and cash.
Yes, we know. For some of you, the world of investing is complicated. There are mutual funds, exchange-traded funds, target-date funds, a variety of bonds and fixed-income products and then, of course, individual stocks.
These days more and more investors are turning to low-cost ETFs. And necessary, there is the question: is it worth taking the time to build an individual stock portfolio? Yes, it is.
But you have to put in some time and research.
We believe an individual investor has an advantage over professional investors. But only if you are willing to do the homework necessary to understand the company, management, and the industry underlying each individual stock.
How can you start picking the companies that go in their stock portfolio?
Building a solid stock portfolio requires some time, research and homework.
The diversified stock portfolio should have 10 to 30 individual stocks.
There are 10 stock sectors classified by S&P Dow Jones Indices. These include energy, materials, industrials, consumer discretionary, consumer staples. Also, health care, financials, information technology, telecommunication services, and utilities.
As a general rule, you would like to own two to three of the top companies in each major sector.
Stock rankings, screeners and lists can help individual investors in their quest to find the best stocks for their needs. The rankings can slice and dice stock market members up by returns, market capitalization, dividend yield, price-to-earnings ratio, and other criteria.
Investing in research doesn’t have to be for professional portfolio managers. It is for individual investors too.
Another way to diversify a portfolio is between growth and value stocks.
Or between dividend stocks and those focused on plowing their profits back into their operations.
Diversification is a beautiful thing because it can lower risk without lowering the expected return of a portfolio. This is more or less related to magic by Wall Street standards.
Use your research and common sense to weed out the industries that you do not like. Or the companies that have historically lost money due to the competitive pressures.
It will be good for you to understand the behavioral psychology and economics at play behind the companies you hold in your portfolio.
For example, knowing the demand elasticity, or how much a change in price will impact the quantity demanded, can be useful in understanding a company or industry’s prospects.
If the price of gas went up 15% tomorrow, it’s very unlikely there would be a corresponding drop in demand. People need to drive, of course.
Establish an investment time frame in your diversified stock portfolio.
Since you are going to own individual stocks you need at least three to five years. The longer the better. In order to reduce certain volatility.
Hence, to be successful in individual stock investing, you must do your homework. But more importantly, you need to have a steady temperament and be confident in your own convictions and analyses.
Building your diversified stock portfolio may be just the beginning. But, for the interested and dedicated investor, the payoffs could be well worth the work.
Picking good stocks requires research, time and the ability to evaluate many parameters for the stock, industry and overall economy.
And while buying a few dividend stocks should earn you some healthy interest income. Your real dividends will be the long-term gains you rack up as you watch your picks grow.