PFN Close-Up: Diversification

Note: From the archives of Physician's Money Digest.

The age-old expression advises against putting all your eggs in one basket. If you're looking for a job, you don't respond to just one ad, you answer several because you don't know which job will be the one to come through. That's the principle of diversification which, when taken in the context of the above advice, simply means to put your eggs—or investments—in several different baskets.

Investing in stocks or bonds means taking a risk, at least to some extent. The goal of diversification is to reduce that risk. For example, in a sluggish economy, one particular asset class or industry might thrive while others languish. Those roles could flip-flop when the economy is on an upswing because not all asset classes or industries rise and fall at the same time or at the same rate. Diversification, therefore, allows for a more consistent performance of your investment portfolio.

A Basic Philosophy

Diversification is truly the foundation around which all investment strategies should be built. That's because when you're looking to grow your investments, you want to minimize risk as much as possible. One example, detailed on the Investopedia.com Web site, examines what would happen if an investor purchased only the stock issued by a single company. If that company's stock did not perform well, the investor could lose a lot of money because there was nothing to buffer or offset the poor-performing stock. However, if the investor split their investment across the stocks of two different companies, total risk is reduced.

To further illustrate, the stocks of two different companies could be from two completely different industries, or sectors—say, an airline and a pharmaceutical company. Events that impact one company's stock and cause it to rise or fall will not necessarily impact the other because the companies are in two completely different sectors. Now, take that same strategy and duplicate it over and over again, to the point where you have approximately 15 to 20 different stocks that are spread across a half dozen or so different sectors, and you’d have a well-balanced investment portfolio.

Too often, investors confuse the issue by thinking that they're well diversified simply because their portfolio is made up of stock from six different companies. If all six companies operate in the air travel industry, the investor has nothing to offset their risk should travelers decide to stay closer to home.

How to Diversify

Another way to reduce the risk in your investment portfolio is to include bonds and cash, as well as stocks. Many investors opt for mutual funds for that very reason. Funds that are referred to as "balanced" often combine a mix of both stocks and bonds, since the two tend to move in opposite directions of one another. The greater the percentage of stocks, the more aggressive the investment strategy and the greater the potential risk.

When building an investment portfolio of mutual funds, remember the importance of diversification. Mutual funds are classified by specific styles, such as large cap (large company), mid cap, or small cap funds. They also may be considered growth or value funds, as well as domestic, foreign, and even emerging market funds. Having your investments in four funds that are all comprised of domestic, large cap stocks does not make for a well-diversified portfolio. It is better to spread your investments across funds with different investing styles.

Keep in mind that it's possible to become overdiversified, something you don't want to do because it can have a negative impact on your investment returns. For example, most experts agree that "20 stocks is the optimal number for a diversified equity portfolio." More is not necessarily better, because if you owned 50 individual stocks, you probably won't own enough shares of any of them to positively impact your portfolio.

Remember, too, that you cannot eliminate risk completely. Diversification, however, enables you to diminish that risk.

Pop Quiz 1. Diversification is a strategy that helps minimize:

a) Growth b) Earnings c) Risk d) Taxes

2. How many individual stocks comprise a wellbalanced portfolio?

a) 5 to 10 b) 10 to 15 c) 15 to 20 d) 25 to 30

3. Owning stock in more than one company guarantees diversification?

a) True b) False

4. You’re well diversified if you invest in five large cap mutual funds?

a) True b) False

5. A well-diversified portfolio could include investments in which of the following?

a) Stocks b) Bonds c) Cash d) All of the above

Answers: 1) c; 2) c; 3) b; 4) b; 5) d.