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Saturday, October 16, 2010

Diversify Your Stocks to Avoid Losses

You have probably heard how important it is to diversify your stock holdings – don’t put all your eggs in one basket.

This is a common sense strategy that unfortunately is lost on some investors when they lock on to a hot stock or get involved in a situation where emotions overcome reason.

Many employees holds only the stock of the company in which they are working. There’s nothing wrong with owning stock in the company you work for, however you should be careful that it isn’t the only stock you own.

Diversifying your stock holdings helps you avoid across the board losses if something goes wrong in a particular industry.

For example, if all of your stock holdings were in the homebuilding industry and mortgage interest rates rose to double digits or the housing market crashed (as it did in 2008), it’s likely your holdings would suffer.

You can own different stocks and still not be diversified. Continuing the homebuilding example above, if you held stock in a homebuilder, a financial institution, a major home retailer and a building material supplier you would not be diversified. These holding are said to have a high degree of correlation, meaning each of these companies may be effected by changes in the homebuilding industry.

What you want is a portfolio that is noncorrelated that is the companies are not part of the same industry and not subject to the same economic influences. For example, a homebuilder, an aerospace manufacturer, a paper goods supplier and a computer manufacturer would be a much more diversified portfolio.

Problems that affected one of the sectors would not likely bother the others.

There are other ways to diversify your portfolio: mixing large, mid and small cap stocks; having growth and value investments and including a small percentage of foreign stocks. However, the most important step is to make sure all of your stocks are not subject to the same economic and market influences.