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Monday, May 2, 2011

How to Diversify your Investment Portfolio?

You probably know it is not a smart decision to put all of your investments in a single stock.

Diversifying your stock portfolio is a smart way to reduce - but not eliminate - risk. Diversification spreads your investments so no one piece will be deadly to your portfolio if it fails.

But, what is the best way to diversify?

You should spread your stock investments in the following ways:
  1. Own big, middle and small companies as measured by market capitalization. The more conservative your strategy is, the larger percentage of big companies.
  2. A more aggressive strategy will favor middle and small companies, since they offer the most opportunity for growth (or failure).
  3. Own companies in different industry sectors - some manufacturing, some financial, some telecom and so on.
  4. Mix up growth and value stocks. If you are more risk oriented, favor growth over value.
  5. Add a small percentage of foreign stocks (usually no more than 5-10 percent).  
  6. You can probably do this with 8 to 12 individual stocks. If you are concerned about picking foreign stocks, buy a good low-fee mutual fund or an Exchange Trade Fund. 
There are two other components you need to consider in diversifying your total portfolio:
  • Bonds should be in all but the youngest investors portfolio. Subtract your age from 100 and that's a good place to start. The answer is how much you should have in stocks. 
  • Cash is always good. When interest rates are low, cash may not provide much of a return, however some part of your total portfolio should be in cash (money market funds, short-term Treasury issues, bank CDs, for example).
If you want to take diversification a step further, add in hard assets such as precious metals or real estate.

There are no hard and fast rules on diversification, but these guidelines will get you started.

Make adjustments based on your investment goals and tolerance for risk. Once you find a mixture you like, stick with it. That means at least once a year you should rebalance your portfolio if needed.