Portfolio Diversification

Portfolio Diversification

Portfolio Diversification

Introduction

Portfolio diversification can be a valuable stock investing concept for every investor whose ultimate goal is to maximize profit and minimize risk. The principle of maximizing profits and minimizing risks is so simple, yet its practice is seemingly an impossible task. While the best investment advice abounds throughout investment circles, any wise and mature approach to investing is the same. Your best protection against risk is portfolio diversification; investing in multiple investment options instead of choosing to place all of your investments in only one area. You can, for example, use the stability of cash investments like CDs and money market funds to diversify your portfolio and offset the liability of stocks, futures, options and stock or bond mutual funds (Sullivan, 2003).

Picking stocks of riskier small growth companies while also investing in the traditional blue chippers, which are the stocks of large, well-established companies allows for a structured stability that will translate to the bottoms line of an investor's portfolio. In other words, when the return is down in one area, it's usually balanced by a positive performance in another. In the simplest terms, portfolio diversification is an excellent hedge against stock volatility and the ups and downs of investing (Sullivan, 2003).

As with any stock trading plan, it is imperative to evaluate assets and realign the investment mix from time to time. For example, as the value of a stock increases, it consumes a larger percentage of the total, thus affecting the total diversification of the portfolio. In an effort to maintain a healthy balance, it may be necessary to decrease the holding in that particular stock and increase in a different area, such as bond or cash holdings. Such decisions require not only experience but the benefit of a method such as candlestick chart analysis (Samuelson, 1967).

In all likelihood, a well-diversified portfolio will contain most, or all, of the following: stocks, bonds, mutual funds, cash equivalents like Treasury bills or money funds, as well as other types of investments. Being able to diversify over a broad range of investment options can help minimize many of the dramatic ups and downs in investing. It has been shown through research that, over extended periods of time, investors are actually able to reduce the level of stock volatility in their portfolios (by diversifying) without sacrificing much in the way of profit at the bottom line (Samuelson, 1967). Establishing a well diversified portfolio is crucial, and it is dependent on available assets, money management, risk tolerance, and long term investing goals.

Example

The simplest example of diversification is provided by the proverb "don't put all your eggs in one basket". By dropping the basket one will break all the eggs: therefore, placing all the eggs in one basket represents an extremely non-diversified strategy. Another simple example of diversification is the following: On a particular island the entire economy consists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is completely invested in the ...