Diversification can help you achieve your long-term investing goals while reducing investment risk in your portfolio. Choosing different types of stocks that’ll react differently to the same events can buffer you against big losses and maximize returns over time.
But it’s just as easy to get carried away and choose too many types of investments as it is to narrow your focus. Effectively managing your portfolio involves deciding how many and what types of stocks you should own along with other assets such as bonds.
If you have too few stocks, you run the risk of getting walloped, especially if you’re focused on one sector or industry. Say all of your holdings are in fast food. You might have choked when workers from the mega-chains including McDonald’s
(ticker: MCD), KFC (Yum! Brands: YUM) and Burger King Worldwide (BKW) organized the industry’s largest-ever strike in April. It’s unlikely that many Americans will give up cheap, greasy food in the near term, but it’s still a bad bet to take too big a bite from a single sector.
There are two basic types of risk — systemic or market — that impact every company. There’s also unsystemic risk, which is specific to an industry, sector, market, economy or country. As an investor, you have no control over risks concerning interest rates, inflation rates, exchange rates or political and social climates.
The most difficult decision is determining how many stocks to pick when building and growing a personal portfolio. There’s no magic number, but keep in mind the fundamental analysis required for choosing a single company and consider how much time you have to scrutinize every stock. You’ve likely heard or read that an individual investor can be dutifully diversified with between a dozen to 20 stocks spread across various industries. But you may need more depending on your risk appetite, goals and how much time for research you can invest.
Diversification is clearly one of the most effective techniques for any investor who seeks to manage risk and reduce the volatility of an asset’s market movements. But there are no guarantees, regardless of your level of diversification, and no risk can be entirely eliminated. Put your energy into reducing risk associated with individual stocks, but recognize you can only do so much to hedge against general market risks.
You’re most likely to achieve your long-term goals by balancing risk and return.