Diversification: A Little
More Than Don't Rest Your Eggs In One Basket
This is something you hear a lot: "don't put all your eggs in
one basket". But how many different baskets do you put it in? Which baskets
should you put it in? What allocation should be in each basket? No one ever
delves into these it seems, until now... thou shalt be informed!
Let's start with the basics, the idea of diversification is
to spread your invested capital (aka. money) across a number of investments so
that when one goes down in value, you have another one that may be going up in
value thereby offsetting the decline in the first investment. This way instead
of having volatile swings that are based on one investment's price movements,
you end up with a less volatile portfolio of investments because of the
offsetting effect mentioned above. Generally all stocks will go up in value
over time, there's a higher probability that it will go up rather than declining.
Therefore you don't have to worry about always having opposite price movements
offsetting the gains.
Can I put my money in any other investment?
Short answer is yes, but to maximize its benefit you should
place your money across investments that are NOT perfectly correlated. In
layman's terms, don't put it into another stock that has price movements moving
in tandem or exactly the opposite to the first investment. If you do, one of
two things will happen: 1) no offsetting effect because they both move in the
same direction and magnitude, 2) the changes are exactly offsetting, leaving
you with zero gain or loss. In essence, don't invest into another company in
the same industry (because of #1 mentioned above), don't invest into their
suppliers if the first company is their major customer (because when the
company fails, there goes the price of their suppliers' stock, #1 above), don't
invest into any other company that has exhibited the same price movements in
the past (eg. during a specific week, A increased 5%, B also went up 5%), and
don't invest into another company that moves exactly opposite to the first
company (eg. A increased 5%, B went down 5% within the same week). If the two
company's stock price moves in a somewhat similar fashion but not always moving
in the same direction and amount, then you should still be okay to invest into
that company. The problem is only when they move in the same or opposite
directions in the same magnitude (amount). For those who are really financially savvy, calculate the coefficient of correlation between the two stocks.
How many different investments should I hold?
No more than 10 to 15 companies if you're doing purely
stocks. Don't remember which textbook I read this from but there was a chart
showing that the marginal benefit of diversification gets smaller as you
increase the number of companies. Also, it may eventually become too much to
keep track of. It is definitely a good idea to mix in some balanced growth mutual
funds and bonds into your portfolio though.
Allocation to reach your goal
Many different goals you may have, for those who want to
preserve their capital while growing moderately, try this mix:
50% Balanced growth mutual fund, they should have monthly
distributions
40% Stocks comprised of companies in the $10 to $29 per
share range
10% Bonds or bonds mutual funds
Just remember folks, whatever you choose to invest in,
always reserve an amount as a safety net. You don't want to be caught with your pants down when an opportunity strikes and you don't have the cash, or if you simply need cash and you're cash-strapped.
Next tip to be uploaded on the weekend, stay tuned!
-TT
