Want diversification? Spread risk among different sizes, styles, areas
— -- Q: I own stocks in companies that make steel, oil, copper and fertilizer. Does that mean my portfolio is diversified?
A: There seems to be a bit of confusion over what it means to have a diversified portfolio.
Investors make the common mistake of thinking if they own a few stocks of companies in different industries that somehow they're diversified. That's not what reams of academic research shows, though.
In order to diversify your portfolio, you need to spread your risk between different sizes and styles of stocks as well as globally. I'll explain what I mean by each below.
Sizes. Stocks' sizes are based on their market value, or the total value placed on a company by investors. Stocks can be small, midsized or large. Small stocks tend to be the riskiest, but have the highest potential return, since the companies are the most untested and face the highest risk of failure. Large companies, on the other hand, often have massive cash reserves and stable business models.
Styles. Next, you need to spread your risk between companies of different styles. A stock's style is based on how richly valued the shares are relative to its net worth, or book value. When investors are paying up for a stock, it's considered to be a growth stock. On the other hand, stocks that are beaten down in value are called value stocks. Generally, you'll want to have a preference toward value stocks since they, over time, have been less risky and have greater returns over time.
Global diversification. Certainly, owning U.S. stocks is a cornerstone of many portfolios. However, you shouldn't limit yourself just to the USA. You can easily invest in companies and indexes of companies in developed and emerging markets overseas. This can be a good idea for the long-term investor.
Going back to your question, if all three of your stocks are U.S-based, small companies with highly valued shares, I'd say you're not diversified at all.
Diversification is a commonly discussed topic among Ask Matt readers. If you want to find out how many stocks it takes to be diversified, you might check out this column:
