Diversifying your investments is an essential strategy for ensuring long term investing success. Diversification is a simple way of saying “don’t put all your eggs in the same basket“. It’s a simple concept that’s employed by every successful investor out there, and one of the most fundamental to investing 101.
Your goal as an investor is to mitigate risk wherever possible, and diversification is one of the most effective ways to avoid watching your money disappear when a stock takes a turn for the worse. Sure, you could get lucky and make a killing from a stock that explodes after you bought it, but there are never any “sure bets” in the market or we’d all be millionaires. The odds are tremendously against you when it comes to long term success if you take this approach.
The risk (and stress) that comes along with putting all your eggs in the same basket simply isn’t worth it. That’s why every successful investor you’ve ever heard of has divided their funds between different investments.
So how should you diversify? Here are 3 key ways to make sure you’re spreading your investments properly.
Invest in multiple stocks
This is probably the first concept investors think of when it comes to diversification. As a general rule, it’s best to divide funds between 5 – 10 stocks at any given time.
Why 5 – 10 stocks? Well, holding less than 5 stocks means that any given stock could amount to more than 20% of your portfolio which means an unexpected dip in a single stock could do significant damage. CNBC investing analyst Jim Cramer says that by holding less than 5 stocks “You’ll be overexposed in a given sector or industry, and unexpected bad news for only one of the stocks could spell major disaster for your portfolio.”
Holding more than 10 stocks means you’re simply spending too much time doing research on new stocks to invest in, and too much time trying to keep up with the news of your current stocks. Remember, a smart investor is an informed investor. It’s crucial to keep up with news that impacts your investments, and unless you’re a full time investor you won’t have time to stay up to date on the important news and trends while holding more than 10 stocks.
Invest in different industries
Proper diversification also means holding stocks in different industries. This protects your portfolio in the case that new regulation comes along, or some other catastrophe happens that negatively impacts an entire industry.
As practical example, take the dot.com crash of the early 2000’s. Investing in only tech stocks would have seen your portfolio obliterated after the bubble burst. From the peak of the the boom to the bottom of the crash the Nasdaq composite (a technology heavy index) lost 78% of it’s value. Ouch, now that’s a tough hit!
On the flip-side, the Dow Jones (primarily non tech stocks) only lost about 36% of it’s value in the same period. Still a major decline, but not even half that of the Nasdaq composite. By properly diversifying your funds to include non tech stocks you would have saved yourself tremendously during this period.
Invest in more than stocks
Finally, it’s also important to invest in different types of assets. Buying stocks of individual companies is, and always will be one of the best methods for investing, but that’s not all there is out there. Having a well diversified portfolio means adding ETFs, mutual funds, government bonds, or even real estate to your portfolio. All of these can greatly compliment your stock portfolio.
There’s no doubt that diversification is an important advantage to have when it comes to investing. While it can sometimes be tempting to put all your eggs in the same basket when you think you’ve found the perfect stock, you’ve got to realize that you may get lucky on certain occasions, but being wrong even once could wipe away your nest egg pretty quickly. Don’t let if happen to you!