What is diversification and why should you care about it?
Essentially, diversification is not putting all of your eggs in one basket when it comes to investing. There are several ways to look at it, but the key is that you are investing in different types of assets. That can mean investing in different asset classes as well as having a variety of types of stocks.
So, where should you focus when it comes to diversifying your portfolio and determining your personal investment portfolio asset allocation?
One way people talk about diversification is in respect to asset classes. Many people believe you should spread your money out between stocks, bonds, real estate, commodities and cash. The following is a breakdown of these five major asset classes:
Stock is simply having a small piece of ownership in a company. Microsoft is an example of a company you can purchase stock in. There are 3 factors to consider when buying stocks and selling stocks.
Bonds are debt. You own a certain amount of debt from a company or government and they pay you interest for that debt. Many companies have bonds that you can buy, and our government has plenty to go around as well.
3. Real Estate
Real estate investing is owning land, and the buildings on that land, as an investment. It is most often associated with buying and managing rental properties. You own the land and make money by renting it out either to an individual, in the case of housing, or to a business, in the case of commercial real estate.
Each has its own set of pros and cons, so you’ll want to do your research to find out what will work for you.
Investing this way means that, even when bad things happen, your entire portfolio doesn’t have to go down. For instance, while stocks and real estate declined heavily during the last recession, precious metals like gold and silver went up significantly. Having something from each asset class can soften the blow when things go downhill. Having some cash and money in safe investments like savings accounts, CDs and money market accounts is a good idea as well.
Another way to achieve diversification is by not having too many similar stocks in your portfolio. In other words, all of the stocks you own shouldn’t be banks or financial institutions. If you had a portfolio like that a few years ago, you would have been in rough shape.
Each category of business is called a sector. The idea is to focus on several different sectors and find the best companies in each. Let’s say you were going to invest in five stocks. You might want a bank, a utility, a healthcare company, a tech company, and a consumer goods company.
The different stock sectors include:
1. Basic Materials
Companies that do things like mining, drilling for oil, or deal with metals such as Aluminum make up this sector. Examples of these companies would be Alcoa (NYSE: AA) and Exxon Mobil (NYSE: XOM).
These are essentially a variety of different businesses rolled into one company. General Electric (NYSE: GE) is a good example of this.
3. Consumer Goods
What do Ford (NYSE: F), Whirlpool (NYSE: WHR), and Hasbro (NYSE: HAS) have in common? They produce goods consumed by the public such as cars, appliances and toys.
Banks and insurance companies like JP Morgan (NYSE: JPM), Bank of America (NYSE: BAC), and Aflac (NYSE: AFL) can be found in the financial sector.
Drug companies, biotechs, and medical parts suppliers are considered healthcare companies. Johnson and Johnson (NYSE: JNJ), Bristol-Myers Squibb (NYSE: BMY), and Eli Lilly (NYSE: LLY) all fall under this umbrella.
6. Industrial Goods
This includes aerospace, construction, tools, equipment manufacturing and other similar industries. Some of the major players are Boeing (NYSE: BA), Caterpillar (NYSE: CAT), and Honeywell (NYSE: HON).
Advertising, retail, railroads, and trucking are all part of the service industry. A few well known service providers are Union Pacific (NYSE: UNP), Walgreens (NYSE: WAG), Best Buy (NYSE: BBY), and FedEx (NYSE: FDX).
Any company that focuses on technology belongs here. Google (NASDAQ: GOOG), Apple (NASDAQ: AAPL), and Microsoft (NASDAQ: MSFT) are all technology companies.
Look no further than your monthly utility bills; electric, gas, and water. Two examples of utilities are Duke Energy (NYSE: DUK) and Consolidated Edison (NYSE: ED).
While having your money in five different companies is better than just one, having them all in the same sector probably won’t help you much. When things are going badly for one, there is a good chance they are all suffering. The financials of the past few years and the tech companies from the dot com bubble can attest to this.
Though investing can be challenging, diversification is really pretty simple. If you keep your stocks from overlapping, you can avoid having too many days when everything you own is down. Invest in different types of companies as well as different types of assets and, in the long run, you will be grateful. Your returns won’t be such a roller coaster ride, and it will help you sleep better at night.
Ecclesiastes 11:2 – Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.
What are your thoughts on diversification in investing? Please share in the comments below!