Diversification

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#6 - Diversification does matter.

The first step in building a successful portfolio is to diversify across several asset classes. Never have too many eggs in one basket. Owning just a few stocks or even a lot of stocks in one sector invites trouble. Any one class of assets (stocks, bonds, real estate, cash) will have its day in the doghouse and its day in the sun. Any one stock can turn out to be a huge winner but it can also be a huge loser.

The Enron lesson is---there is danger in owning too much of a single stock. Your second highest risk—counting on just a handful of stocks. Your third risk---investing in only one sector of the market.

To make sure that you capture the historical advantage of stocks, your portfolio should include a broad range of companies---growth and value, small-cap and large-cap, technology, etc. That’s why you’ve got to own them all in a mix that’s right for your age, income, responsibilities and tolerance for risk.

Some research indicates that allocating a portfolio into various types of investments is far more important than the choice of specific securities.

Instant diversification occurs when you make index investing a core piece of your portfolio. Every market goes through periodic downturns. An index investment in the total market provides you with diversification in small, medium and large companies. Indexing enables an investor to always keep pace with the market without effort. It will not rule out risk but index investors predictably receive the market return.

With index investing, you don’t have to worry about your fund manager picking bad stocks or loading up on cash just before a market rally. It takes a lot of anxiety out of stock market investing. Whatever happens to the market, that’s what you get.

Broad diversification rules out extraordinary losses relative to the whole market but it also, by definition, rules out extraordinary gains.