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Achieving efficiency in business is particularly tricky and one of the biggest mistakes that investors can make is to fail to properly diversify their portfolios. But we’ve already heard that from our grandmothers: never put all your eggs in one basket. So it should be solid advice even when it’s not eggs that you’re concerned about.
So how does one go about creating a diversified equity portfolio? The entire issue with diversification is more common sense than anything. Imagine that you were the owner of a fast food chain such as KFC or McDonald’s. Even if you’d have excellent profits for several years, a healthy fad diet hitting the U.S. would cause profits to plummet. Had you, on the other hand, invested in more than just fast food chains, believing that this meant to diversify, you would have had the horrible surprise of losing as much as someone who would have invested all of their money in just McDonald’s. It’s not about the number of companies you invest in, it’s about investing in various types of companies. It would be counterproductive, for instance, to invest in Home Depot’s rival if you already own Home Depot shares. You’d be much better off investing in a franchise or an oil giant.
But how do you make these decisions? There is a widely used scientific approach based on the Global Industry Classification Standard. This system classifies all companies into one of the 10 general sectors, which include health care, telecommunication services, IT, utilities, financials, industrials, energy, materials, consumer discretionary and consumer staples. Say you own shares in one IT company and a company in the telecommunication services category. The next stocks you should consider buying would best serve you if they would belong to the other 8 sectors.
How many stocks should you have? This is a delicate question, however, it’s clear that owning seven is much better than owning just one. Experts believe that there is a point over which owning more stocks doesn’t significantly improve your portfolio. Generally, optimal diversification is reached at approximately 15-20 stocks which the investor has spread across the 10 industries we’ve mentioned.
If you have already invested in the materials sector, why not consider the IT sector: possibly, investing in web property. This site, for instance, offers excellent opportunities. Or if you’ve already invested in IT and telecommunications, you’d do right by choosing to pursue the energy sector. Your main concern is to control volatility and to reduce risk to a minimum. Granted, investment risk can never be brought to zero, even with a perfectly diversified portfolio, however, finding the right balance between risk and return can make you more comfortable in the long run.
