How diverse is your portfolio? If you’re not sure, you’re not alone! According to a 2019 survey published by CNBC, only 42% of today’s investors actively ensure that their investment portfolio is diversified. More surprisingly, roughly one in four investors say that they’re not sure what investment diversification even means.
This only points to the ongoing need for investment education. At Gorilla Trades, we want every investor to make the right choices for their portfolio. With this in mind, we’ll explain a bit more about how to pursue diversification.
What is Diversification?
Just like you would never put all your eggs in one basket, you should never place all your money in any one single investment.
No matter how well you research an individual stock, you can never be fully prepared for market fluctuations or a company’s bankruptcy.
For this reason, investment experts recommend that you distribute your money evenly across a range of assets. By doing so, you can protect yourself against risk, as the success of your other investments can provide a bit of a safety net if one of your stocks should suddenly plummet.
How Does Diversification Protect Investors?
Generally, there are two types of risk that can impact investors. Systematic risk (or “market risk”) refers to broad, structural changes in the market, often caused by major shifts in investor behavior or broader events like natural disasters or war.
This means that every asset you own can be impacted — even the value of your cash can be affected by inflation.
How can investors shield themselves from this type of risk? By diversifying investments across a range of asset classes (cash, stocks, bonds) investors can find some protection from major events. For example, if the entire stock market crashes, a savings account full of cash prevents you from losing everything.
Unsystematic risk (or “asset-specific risk”) is probably the risk you most commonly think of when you consider diversification in investing. This refers to major fluctuations in the stock price, as well as the overall performance of the company.
Every time you invest in an individual stock, your potential return is directly connected to that company’s performance.
When you diversify your portfolio, you’re basically seeking to balance the risks associated with a particular company against the potential rewards.
In other words, the more stocks you have in your investment portfolio, the less you’ll “feel” the impact if one of them should suddenly decline in value.
Likewise, the more stocks you own, the more likely it will be that you’ll benefit if one of them should suddenly take off. Diversification is about finding the right balance between risk and reward, which is why it’s a time-honored strategy for long-term investing.
How Many Stocks Do I Need to Diversify My Portfolio?
This raises an important question: How many stocks make up a diversified portfolio? There’s actually no “right” answer to this question. It often depends on your investment goals and level of familiarity with the market.
If you’re new to investing, you may find it difficult to invest in a large number of stocks right off the bat, even if you invest through a diversified mutual fund.
With that being said, financial experts generally agree that investors should aim for 20 to 30 stocks in their portfolios. Some would even say that after 30 stocks, investors don’t see much benefit from diversification.
How to Achieve Diversification By Asset Class
There are three general types of asset classes that you can use to create an investment portfolio:
- Stocks
- Bonds
- Cash
Bonds are similar to stocks. Rather than investing in the company directly, however, you’re essentially loaning money to a company or the government in exchange for an interest payment. This can make bonds a bit more reliable (as long as the company is healthy), though returns tend to be more modest when compared to stocks.
This is not to say that your investment strategy can’t also include other investments like real estate or precious metals or valuable commodities like art.
Some investors are also placing their hopes in things like Bitcoin, though it’s not altogether clear how cryptocurrency will evolve in the long term.
The point is that diversifying your asset classes can protect you if one of your assets should suddenly drop. For example, if your stock picks should suddenly drop, you won’t have lost everything as long as you still have money tied up in a savings account or a piece of real estate.
Diversifying your investments can ensure that your overall financial position is protected from events that impact any one asset class.
How to Achieve Diversification in Your Stock Portfolio
Most investors are concerned about diversification when it comes to investing in the stock market. There are three basic ways of doing this. Investors should ideally attempt to incorporate all three strategies as they make investments.
Sector
Diversifying means more than just buying stocks from a lot of different companies. Investors should make sure that these companies operate in distinct industries or sectors of the stock market, too.
For example, Apple and Microsoft both belong to the tech sector, while Coca-Cola belongs to the consumer staple sector. Diversification demands that you invest not only in multiple companies, but multiple sectors.
Additionally, you’ll want to pay attention to sectors that are impacted by a specific economic cycle. Some companies (like clothing, real estate, and financial services) will be impacted by the nation’s overall economic cycle, which means that the success of these companies is driven by overall consumer demand.
On the other hand, consumer staples stocks, utilities, and healthcare will be largely independent of economic trends, which means that they can provide more stability. A well-balanced portfolio will include stocks of each type.
Growth and Value-Oriented Stocks
Investors should seek to purchase both growth and value-oriented stocks. Growth stocks are those that are expected to increase in the near future. Growth stocks can be expensive, but if the company performs well, investors can expect big returns.
Value stocks represent companies that are currently undervalued or underpriced. Investors may be able to get a good deal on a stock when it’s offered at a low price, then reap the rewards if the stock should rebound.
Market Cap
What is market cap? Market cap refers to the total value of a company’s stock.
You can calculate the market cap by multiplying the current share price by the total number of shares. In other words, the market cap tells you how large a company is.
To diversify your portfolio, you should invest in companies of varying sizes. Larger companies can offer more stability in times of financial uncertainty, but small to mid-sized companies can offer a greater potential for growth.
How Can New Investors Diversify Their Portfolios?
For new investors, few things are as important as diversifying their stock portfolios. But if experts recommend a minimum of 20 stocks, this can be a tall order. There are several ways to accomplish this feat, however. The one you choose may depend on your individual investment style.
Mutual Funds, ETFs, and Index Funds
Stocks don’t have to be purchased individually. They can also be purchased as a collection through a mutual fund, an index fund, or through exchange-traded funds (ETFs).
These options can quickly provide you with a diversified portfolio without having to do a lot of your own research. Even today’s investing apps can provide “roboadvisors” to assist in the process.
Setting up a mutual fund doesn’t prevent you from making adjustments as you go, whether it’s adding stocks to your portfolio or jettisoning underperforming assets.
The great advantage to these types of funds is that your financial broker can do a lot of the legwork for you. If you’re not quite comfortable with researching stocks and monitoring their performance, a brokerage firm can provide assistance, so long as you’re willing to pay a brokerage fee.
Target-Date Funds
Target-date funds are used when you want to cash in your assets on a particular date. This makes them ideally suited for use as retirement accounts.
These funds rely on a fund manager to actively manage your portfolio, which can make them a bit more expensive than other investment vehicles. Still, these can be a good option for people who prefer to let their assets be handled by a professional.
Fractional Shares
Some brokerage firms will allow you to purchase fractional shares in a company. For instance, you might want to only purchase 50% of a company’s stock share. The money saved by purchasing fractional shares can help you to quickly develop a diversified portfolio without demanding a huge investment upfront.
This approach can be a great way to get used to the process of researching and selecting your own stocks. There are a number of useful tools available for researching your stock picks to help along the way.
Invest Like a Pro with Gorilla Trades
Diversification in investment isn’t hard to achieve as long as you have the right tools. That’s where we come in! Gorilla Trades members get exclusive access to our library of tools and resources aimed at helping them to maximize their investments.
Why not see for yourself by signing up for our free, no-obligation trial? Take the next 30 days to see what Gorilla Trades has to offer and how you can move further down the path toward financial success.