www.Money-and-Investing.com

This is part of a larger article called The Golden Rules…

Diversification is a fancy way to say “don’t put all your eggs in one basket”. If you own the right number of stocks, bonds and funds and they are allocated across several categories, industries and geographies, you can substantially lower the risk of losses to your portfolio and increase returns at the same time. What?! That’s right, if you diversify properly, you lower risk AND improve returns at the same time, making this a no-brainer. How does it work? Diversification is the process of finding the investing sweet spot where you optimize the risk Vs return of your portfolio.

Uh oh, “optimization”… sounds like you’re about to be bombarded by statistics doesn’t it? It sounds complicated but it’s not. There are only three things you need to focus on as you create your portfolio to make sure you’re creating diversity; the number of securities, the mix and the asset allocation.

I’ve always felt that owning between 25 and 30 securities is the optimal number but this can vary based on strategy and risk tolerance. Less than 25 and you haven’t truly diversified, your losers can still really hurt your overall returns. More and you get diminishing returns from too much diversification, you might as well buy an index fund and let it ride if you’re going to carry 50 or more stocks. 25 to 30 securities is a lot, and many beginners don’t have that kind of cash when they start investing. Don’t worry, mutual funds were made for you, many of the best ones will give you full diversification with an investment as small as $500. Click on the following links if you want to learn more about Index Funds or Mutual Funds before you finish this article.

The second critical piece is the diversification mix. You want to invest in a wide variety of industries, categories and geographies to ensure that when one specific area goes south, it doesn’t tank your whole portfolio. For example, if you own a telecom and suddenly the industry is getting bad press due to invasion of privacy lawsuits, the rest of your portfolio can cover the losses of that stock. Why? If you’re diversified, that’s probably your only telecom, the rest are in unrelated industries and won’t be directly affected by these lawsuits. Also, your portfolio should be spread across a wide variety of categories and geographies, most of which won’t correlate with anything going on in telecom, some may even be inversely correlated (meaning they do well when telecoms do poorly).

Finally, make sure you have a diverse asset allocation. This means spread your money between various types of investments. Don’t buy only stocks, bonds or funds, buy a combination. The reason you want a blend is because each type of investment behaves very differently. Stocks, for example, have the highest potential return of any type of investment but they also have the highest risk of losses. Bonds, on the other hand, can’t provide the types of returns a stock can but they offer stability since their returns are often guaranteed. A blend of different asset classes is just another way to diversify and you can choose from a wide variety of allocations. Here is a good rule of thumb. The further you are from retirement the more you should allocate to more aggressive investments like stocks, and the closer you are to retirement the more you should allocate to shorter term lower risk investments like bonds

Best of luck and please add your thoughts to this post, we’ll all benefit from your questions and insights.
~ Odd

Back to main article, The Golden Rules…