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What is Asset Allocation & Stock Investment Diversification – Definition & Strategy

By Derek Clark

diversification eggs basketWhat 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?

Asset Classes

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:

1. Stocks
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.

2. Bonds
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.

4. Commodities
These are things like gold, silver and oil which, generally, come out of the earth and are in demand.

5. Collectibles
Famous artwork, coins, and valuable antiques are examples of collectibles you can invest in (and makes for a fun hobby too).

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.

Stock Sectors

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).

2. Conglomerates
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.

4. Financial
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.

5. Healthcare
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).

7. Services
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).

8. Technology
Any company that focuses on technology belongs here. Google (NASDAQ: GOOG), Apple (NASDAQ: AAPL), and Microsoft (NASDAQ: MSFT) are all technology companies.

9. Utilities
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.

Final Word

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!

(photo credit: Shutterstock)

Derek Clark
Derek Clark is a software designer and personal finance blogger who lives with his wife in Middle Tennessee. He likes to bowling, golfing, reading, playing softball, shooting, and talking about politics or personal finance. You can read more from Derek at Christian Common Cents.

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  • http://www.financiallydigital.com Nunzio Bruno

    Diversification is a fun topic to cover isn’t it. Nice break down in your post by the way. I think when you are approaching this stuff risk tolerance is a big piece of the choices you make. I like equities for the most part..i’ve been dipping my hand in forex these days which is proving to be pretty fun. As far as places to go I think that financials, tech and services are going to see a nice bump this year as discretionary income becomes more available for people.

  • http://www.mypersonalfinancejourney.com/ Jacob @ My Personal Finance Journey

    Nice post here about a good topic in asset allocation! I have read many mixed opinions for the past couple of years between whether or not collectibles and commodities are beneficial to add to your mix of asset classes.

    What’s the best way you’ve found to invest in these?

  • Derek Clark

    As far as collectibles and commodities go I haven’t done much investing in either. I’d actually like to put some money into artwork, but I need to have more liquid investments first. The biggest problem with art is obviously finding a way to sell it for what it is worth. As far as commodities go, there are two options as far as I’m concerned. The first would be to take a small fixed portion of the portfolio (i.e. 5% or so) and invest in the GLD ETF. The other option which I like better is to find a well run company which has exposure to them. Something like FCX comes to mind.

    • http://www.mypersonalfinancejourney.com/ Jacob @ My Personal Finance Journey

      Interesting! I think the gold ETF is probably something I could do. Do you know if it is an index-based ETF or is it actively managed? I tend to want to stick with the index based ones.

      • Derek Clark

        I would consider it more index-based. Essentially they just buy gold bullion. The expense ratio is 0.4%

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