Two More Reasons To Diversify

By Gregory S. Davis | June 01, 2009 AAA

The unimaginable has happened. General Motors (NYSE:GM) and Citigroup (NYSE:C) are slated to be removed from the Dow Jones Industrial Average (DJIA) and will be replaced by Travelers Companies (NYSE:TRV) and Cisco Systems (Nasdaq:CSCO). While foretelling the removal of these two global brands from the DJIA 10 years ago may have been improbable, the benefit of diversification moves front and center.
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How Does Chapter 11 Affect My Stock Holdings?
The liquidation of a company and the zeroing out of a stock typically happens when a company files Chapter 7 bankruptcy. Unlike its bankruptcy filing sibling, Chapter 11 bankruptcy - announced by General Motors on June 1 - allows a company to carry on with its operations while it transforms into a leaner version of its previous self. The Securities and Exchange Commission makes it clear that in most Chapter 11 cases the company's plan of reorganization will cancel the existing equity shares. This is the reason investors should remember their place in line behind secured (banks) and unsecured (bondholders) creditors who stand to be repaid first before common stock holders.

How Many Stocks Constitute A Diversified Portfolio?
The right answer is up for debate, but I'm comfortable with the number of individual holdings for a diversified portfolio falling somewhere between 12 and 16 stocks.

A baseline for building a diversified portfolio for the avid stock picker could be the sector allocation utilized by the SPDR S&P 500 Fund (NYSE:SPY).

Sector % of
Total

S&P 500 Proxies

1

TECHNOLOGY 17.06% Cisco Systems (Nasdaq:CSCO)

2

HEALTHCARE 15.17% Amgen
(Nasdaq:AMGN)

3

OIL & GAS 12.98% Exxon Mobil
(NYSE:XOM)

4

CONSUMER SERVICES 11.93% Wal-Mart
(NYSE:WMT)

5

CONSUMER GOODS 11.43% Kraft
(NYSE:KFT)

6

FINANCIALS 11.36% Wells Fargo
(NYSE:WFC)

7

INDUSTRIALS 11.16% 3M
(NYSE:MMM)

8

UTILITIES 4.55% Duke Energy
(NYSE:DUK)

9

TELECOM 3.92% Verizon
(NYSE:VZ)

10

BASIC MATERIALS 2.58% Alcoa
(NYSE:AA)

The percentage of total investment can be changed based on your personal preference, but a stock from each sector would be a great place to begin. To go beyond the 10 stocks derived from the S&P allocation, investors can take note of asset classes used by the Harvard endowment and include a foreign stock, an emerging market stock and an investment in a stock tied to real assets like a REIT or agriculture.

Alternative Methods To Gain Diversification
There is always the option for investors to choose from a host of mutual funds and ETFs to gain even greater diversification in order to avoid being subject to the fate of any one company. Looking ahead, investors should still ask themselves if the companies they choose will be around 10 years from now, but proceed with a plan to keep their portfolios alive with an eye focused on diversification.

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