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What is Stock Diversification, and Why Is it Important?

stock market diversification

When you think of stock diversification, remember just one idiom: Don’t put all your eggs in one basket. Think of it this way: Do you apply for only one job? Or do you apply to multiple companies? 

A smart person applies to many companies to increase their chances of getting a job in case they don’t get an offer from their favorite company. That’s exactly what stock diversification is. Buying different stocks so that if one stock does badly, the other stocks can provide solid returns.

A lot of people think diversification is just buying a lot of stocks. However, this is only partly correct. Human psychology makes people invest in sectors they are comfortable in. For example, an individual who understands finance well might invest primarily in bank stocks. 

Source: Fidelity Investments

Sure, they will invest across multiple banks so that if one bank faces a problem, the other bank stocks in their portfolio will make up for their losses. But what happens when the whole banking sector faces a crisis like the 2008 financial crisis? Several people lost significant capital when banking stocks crashed and burned between 2008-10.

Is diversification good for stocks?

Stock diversification is when you buy stocks of different companies from different industries so that if any one industry or one company suffers, you don’t lose all your money. For example, you can buy three stocks from the tech space, three stocks from banking, three stocks from retail, and so on. 

This takes the ‘Don’t put all your eggs in one basket’ metaphor a step further. Now, you ‘Don’t put all your baskets on one train.” You are thinking, “That’s great. I’ll just buy the top three stocks from 3-4 sectors.” That’s a sound idea, but you can diversify further.

When you buy the top three stocks from 3-4 sectors, you are only buying large-cap stocks. This is a very good strategy when you want to play safe. However, if you want some extra bang for your buck, it makes sense to assign a small portion of your funds to mid-and-small cap companies. 

These are companies with market capitalizations between $1 billion to $15 billion (mid-caps) and those between $200 million to $1 billion (small caps). These stocks are more volatile and have a higher chance of failure, but they can also grow explosively, giving you extraordinary returns on your investment.

Multiple stocks from different sectors? Check. Large-cap stocks? Check. Mid-and-small cap stocks? Check. Is there anything else you need to keep in mind? Yes. Look at companies that have operations and revenues coming in from other countries. 

For example, technology companies like Google, retailers like Wal-Mart, and banks like Citibank have revenues coming in from across the globe. This becomes very important in today’s world as threats of the pandemic can lead to individual countries imposing lockdowns which could hurt economic activity. Investing in companies that make money across the world mitigates this risk.

What is a well diversified stock portfolio?

Isn’t it a challenge to choose so many stocks from so many sectors and so many geographies?  The easiest way to diversify your stocks is to invest in ETFs (exchange-traded funds). ETFs don’t select stocks individually; they invest in all the companies in an index or a sector or geography. 

For instance, some ETFs track the S&P 500; others track the Nasdaq (all tech stocks); some energy ETFs track energy companies; there are ETFs that invest in Chinese companies, and some that invest in European companies, and so on and so forth. You can also choose to invest in mutual funds that invest across companies. 

There are large-cap mutual funds, mid-cap mutual funds, and small-cap funds. There are also sectoral funds that look at technology, communications, industrials, infrastructure and so on. Mutual funds are more expensive than ETFs.

The younger you are, the more risk you can take with mid-and-small cap stocks. You need risky assets because risky assets can deliver outstanding returns over a long period of time. Conservative investors can choose large-cap mutual funds, while newbies to the market can choose ETFs. 

While a large part of your portfolio (around 45-55%) will primarily focus on large-cap stocks in the US (or your home country), around 15-20% can be invested in mid-and-small cap stocks, 15-20% in emerging markets, and 15-20% in foreign stocks. The older you get, the lower the amount of mid-and-small caps in your portfolio.

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