1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion

Individual investors approach the markets from a very different perspective from institutions. Due to the size of an individual investor’s asset pool, he or she may not be able to tolerate short-term fluctuations in the stock market. One way to address this issue is through diversification.

Diversification is a means of managing risk, and it is accomplished by mixing a variety of financial instruments within a single portfolio. The goal of diversification is to minimize the impact that the performance of any one security will have on the overall performance of the whole portfolio. As such, diversification lowers the risk associated with the portfolio. (Related: The Importance Of Diversification)

While diversification is a straightforward concept, the practical application can be quite complicated. Indeed, there are numerous complex formulas to demonstrate how diversification works. Still, for our purposes, a single brief example should help to clarify:

Imagine that you live on an island and there are only two companies making up the economy. One company sells sunscreen and one sells umbrellas. If you were to invest your entire portfolio in the company selling sunscreen, you would see strong performance during the sunny parts of the year, but poor performance when it rains. The reverse would occur if you placed all of your assets in the other company as well. Most investors would prefer to have steady and constant returns. The solution in this case might be to invest 50% in one company and 50% in the other. The result of this diversification is that you would have decent performance throughout the year, as opposed to excellent performance at one time and terrible at another.

This example is overly simplistic, but it illustrates the way that diversification, when applied properly, can minimize risk and smooth out returns. Here are the three main practices which can help to ensure optimal diversification of a portfolio:

1. Divide your portfolio among multiple investment vehicles, such as cash, stocks, bonds, mutual funds, and more.

2. Vary the level of risk in the securities in which you invest. Pick investments with varied risk levels. This will help to ensure that large losses are offset by gains in other areas.

3. Vary your securities according to industry. This helps to reduce the impact of risks that are industry-specific.

There is perhaps no single greater factor in helping an individual reach his or her long-term financial goals while minimizing risk than diversification. Still, though, diversification is not a fail-proof guarantee against loss. Virtually any investment takes on a certain degree of risk, regardless of how much diversification you employ.

Many investors wonder how many stocks to buy in order to optimize their diversification. Portfolio theorists have suggested that the number seems to be around 20 securities. At this rate, when properly distributed among company size, industry, and other factors, these securities help to reduce individual risk.

Next up, we’ll look at dollar cost averaging.

 


Financial Concepts: Dollar Cost Averaging
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