Proper Diversification

A MIXED BAG
Diversification is a risk management strategy that mixes a variety of investments in a portfolio, the goal being to reduce exposure to one sector, industry, or an overly weighted stock within a portfolio. This aims to protect the portfolio when a tradable takes a turn for the worse.

Diversification eliminates the fear that one stock or sector will damage a portfolio's worth. If a sector turns negative, you'll have small losses in the portfolio. The absorption of these losses allows the investor to trade another day. For correct diversification, an investor must pay particular attention to the sectors that portfolio is exposed to. Diversification calls for a variety of investments from cash to business investments and bonds as well as stocks and commodities if necessary.

The biggest factor in diversification is the value of the portfolio. A larger portfolio will have vastly different diversification requirements than a smaller one will. Whether your portfolio is large or small, however, you will still need to be diversified.

Many investors with small portfolios begin to diversify through mutual funds instead of individual stocks or bonds. Mutual funds allow an investor to purchase a basket of securities by buying into a fund. Their simplicity have made them Main Street's favorite way to diversify. While purchasing mutual funds can help diversify a portfolio, however, it's not a given; investors can purchase multiple funds with similar portfolios. This can cause a portfolio to be overly weighted in an industry or sector, exposing it to unnecessary risk.

Whether they are novices or experienced, investors and traders tend to overweight their portfolios, placing all their eggs in one basket or make one part of their portfolio bigger than the others. This happens when a particular sector becomes popular and investors feel as though they need to be in it. When they do, they tend to overweigh their portfolio, inadvertently allowing any adverse turn in that sector to damage their portfolios.

Overweighting is even easier when you consider the size of publicly traded companies, many of which are in multiple industries, thus confusing many investors about what they actually are and do. Knowing the primary business of your stock's company is important. Investors and traders must know what industry and sector the stock they are holding are actually in to make a reasoned decision about what to buy for their portfolios.

This is not as simple as it sounds. It is not uncommon for a large corporation to be involved in many different industries. Knowing the primary business the stocks you own are in and how they make the bulk of their revenue will make it easier for you to diversify. You need to be able to place each stock you own into a category, making it easier to identify any duplicate sectors or industries your portfolio is exposed to.

On a lesser scale, self-directed investors not able or willing to pay a professional to manage their accounts can manage their own portfolios by limiting their investment choices to stocks, bonds, and cash. This kind of portfolio will usually be shy of futures contracts as well as other nonmarket investments.

The exposure between stocks, bonds, and cash is easier to manage for the self-directed investor. Such a portfolio is weighed heavily in stocks with some cash and bonds mixed in. The disadvantage is that there is less diversification, with little or no exposure to precious metals or commodities. Since these sectors go through long uptrends, many self-directed investors cannot include them because they do not have the experience or knowledge to properly add them to their portfolio.

Such investors who do not have extensive knowledge or experience can diversify using a blend of mutual funds and cash. In such a portfolio, the bond and stock portions are made up entirely of mutual funds. Much like a retirement account, the portfolios of such self-directed investors can have their exposure to cash and bonds increased while lessening their exposure to stocks and vice versa. This type of portfolio means the only decision the investor needs to make is when to change the makeup of their portfolios. This leaves the individual investor free to only be concerned about the current financial and economic climate.

The biggest advantage of this type of portfolio is that individual investors still have professionals managing their accounts via the mutual fund. Nevertheless, this portfolio can still be quite complex to manage. Besides just worrying about when to move into and out of cash and other investments, the investor must also search for and select the correct mutual fund or mix of funds in order to properly balance their portfolio. With so many mutual fund choices available, the task can be a daunting one.

The other downside comes in the form of fees. These mutual funds are actively managed, so there are fees and expenses as well as tax implications the investor needs to keep in mind when it comes to mutual fund ownership.

Before ETFs, the self-directed investor needed to either pick individual stocks or go to the futures market and buy their respective contracts. ETFs are not confined to futures investing, however. ETFs allow you to add exposure to a particular sector or industry. Often, an ETF can be the easiest way for an investor to add exposure to futures markets, foreign bonds, or even corporate bonds. You can add or lessen exposure to these sectors by simply buying or selling the proper ETF. Adding ETFs to your current portfolio quickly helps diversify your portfolio.

The best way to add ETFs to your portfolio is to first look at your current portfolio and then determine if it is too heavy in one sector or stock. Is your portfolio a little light in bonds or metals? If so, you can add exposure to those markets by adding ETFs.

Think of ETFs as stocks that can be bought and sold throughout the trading day without having to deal with net asset value (NAV). Since ETFs are traded like stocks, you can benefit from the low cost of purchasing shares, depending upon your broker. Unlike mutual funds, most ETFs are not actively managed. When you have managers adjusting and readjusting a portfolio, you will have fees associated with this and that, adding an extra cost not found in ETFs.

Choosing the right ETF to fit your portfolio does require some work. Due to their overwhelming popularity, there are so many choices now that many duplicate ETFs are floating around. You will also want to steer away from less popular or thinly traded ETFs. Some ETFs are not as liquid or easy to get in and out of as others are.

Diversifying your portfolio is not an easy task, but with patience and the right blend of the different investment choices, a properly diversified portfolio is within reach to all investors, regardless of the size of their portfolio.