John’s concept of stock portfolio diversification is like a child saying, “fiscal cliff.” He has heard the phrase, know it’s popular and has some idea of what it means, but he really doesn’t understand all the implications of it and why it is so important to investing. That is not meant to suggest that these John is simple-minded, it just means that he doesn’t really know why he needs to diversify his stock portfolio or how he should do it.
Why Diversification is Essential
John works in the natural gas industry and he sees that the industry is booming, so he decides to buy stock in various natural gas companies. For the first year, John does great because all his stocks are going up in value. Then, the EPA sets new restrictions for natural gas extraction and industry stocks go down across the board. John takes a whopping loss because all the stocks he bought were in the same industry sector, In other words, he didn’t hedge his investments.
The Consequences of Not Diversifying
John took all losses when the market dropped because he didn’t have gains on any other stocks to balance out his portfolio. If he had diversified his holdings, say by holding stocks in another industry that had an upturn, he might have evened out his losses, or possibly even still made a profit if the other stocks yielded a higher return than his natural gas stocks lost. But, since he didn’t do that, John has no choice but to hold bad stocks and hope they go back up again.
Risk vs. Reward
As a stock investor, you need to take bigger risks in order to reap bigger rewards. In some ways, the stock market is a like horse-racing. If you bet on the long-shot and it comes through, you’re going to get a much better payout than if you had gone with a “sure-bet”, that’s a large part of what makes the stock market attractive to investors. That being said though, and according to Value Stock Guide, every investor has a risk-tolerance level, meaning they can only afford to lose so much. In order to reduce their risk, investors need to diversify their holdings.
Poor John learned his lesson the hard way, but that doesn’t mean that you need to. While it’s good to invest in an industry you know, generally speaking, you should also branch out into other sectors. It’s also not a bad idea to look at your financial portfolio as a whole and not put all your money into any one commodity. You can but your favorite stocks, but consider some other investments like mutual funds, bonds, options and or futures. “Spread the wealth” so that if you pick some losers, you also have some winners to help keep things in your favor.