7 Layers of Stock Diversification

Worldwide Invest Better Day 9/25/2012

This month at The Motley Fool we've dedicated ourselves to getting back to basics, culminating on Sept. 25 with Worldwide Invest Better Day. With this in mind, my Foolish colleagues and I are unleashing vital information to help you invest better. Today, we'll review stock diversification, a key fundamental of investing.

Think of a well-performing portfolio like a properly made seven-layer cake. Applying layers of diversification to your stock portfolio increases your odds of investing success. First we'll address why diversification is so important, then we'll dive into the delicious layers one by one.

Why all this diversification mumbo jumbo?
At the core of diversification lies the idea of correlation, a measure of how the returns of two investments move together. Some investments' returns move in the same directions; others move in opposite directions. The goal of diversification is to own a basket of investments whose returns move in opposite directions so that even if a portion of your portfolio is deteriorating, the rest of your portfolio is growing. In essence, we potentially mitigate the impact of poor market performance on our overall portfolio. Diversification doesn't guarantee against losses, but it narrows the range of potential outcomes.

Delectable layers
Let's take a closer look at what I call the seven layers of stock diversification.

1. Target how many stocks to own
Studies have shown you can achieve a well-diversified portfolio with as few as 15 and as many as 30 stocks. If individual stocks are to make up the majority of your portfolio, shoot for 25 to 30. To avoid concentrating too heavily in any one stock or sector, keep your stock portfolio at a minimum of 15. Dollar-cost averaging -- contributing a set amount of money at regular intervals -- is a strategy you can use to buy a specific number of stocks over a period of time.

2. Don't overconcentrate
Fidelity feels an investor should have no more than 5% of their total portfolio in any individual stock; Schwab thinks 10% is more realistic. Depending on whom you listen to, this answer will vary. But regardless of whose advice you heed, don't put so much money in any one holding that if you lost it all you'd be heartbroken or destitute.

3. Balance across sectors
Sectors perform differently during bull, bear, and flat markets. Those considered "defensive," including consumer staples, utilities, telecom, and health care, typically aren't as affected by a downturn in the economy as the more economically sensitive sectors like industrials, energy, financials, consumer discretionary, and tech. A portfolio that includes all sectors has the best chance for success over the long haul regardless of market conditions. Best of all, instead of being glued to CNBC speculating as to which sectors may zig and which may zag, you can be playing golf, gardening, or doing whatever suits you.

4. Dig deeper into subsectors
Let's take the tech sector as an example. Within it there are companies that specialize in hardware, software, semiconductors, and communications equipment. Owning only Intel (Nasdaq: INTC  ) puts you at risk if something detrimental happens to the semiconductor market, or if prevailing trends move away from the chipmaker's PC focus toward more challenging markets like mobile chips. But adding Apple (Nasdaq: AAPL  ) , a company that sells iDevices and a bunch of related services, gives us a deeper level of diversification within the sector. Both tech companies boast strong balance sheets with low debt levels and generate substantial free cash flow, but owning both helps you further diversify within the sector.

5. Screen for suitability
Stocks are categorized into different market capitalizations, or sizes, including small, mid, and large caps. Stocks also pay different degrees of dividend income to shareholders. Do you need income now or can you forgo it? Your answer may lead you to skew your portfolio toward either more income-producing dividend stocks or more growth-oriented non-dividend-payers. An investor hungry for income is likely to find Annaly Capital (NYSE: NLY  ) and Retail Opportunity Investments (Nasdaq: ROIC  ) , with their respective 12.7% and 4.5% dividend yields, far more palatable than a small-cap non-dividend-payer. Even though the two companies are managed very differently from each other, they are similar in generating mouthwatering dividends for income-desiring investors.

6. Don't forget about international exposure
Geographical diversification counts, too. Chipotle Mexican Grill derives practically all of its business domestically -- of its 1,230 locations, only four are outside the U.S. But Arcos Dorados Holdings (NYSE: ARCO  ) , the largest McDonald's operator in Latin America, obtains 100% of its revenues internationally. So when the Brazilian economy weakened, it affected Arcos Dorados, which slowed expansion plans, but not Chipotle. Of course, if the geographic tables were turned, the converse would be true.

7. Monitor and maintain balance
Once we've built a beautifully layered cake, let's not take our eyes off it only to have it topple over. In order to maintain balance, we need to monitor our portfolios. Sometimes the hardest part of being an investor is selling winners and rebalancing, but smart investors do this systematically and free of emotion.

You: A better investor
Now that you're supplied with a recipe for stock-investing success, join us for more investing basics. Consider this your engraved invitation to honor us with your presence on our microsite for Worldwide Invest Better Day. On the site, we'll be posting a veritable cornucopia of articles aimed at helping individuals become even more awesome investors.

 

Fool contributor Nicole Seghetti owns shares of Apple and Intel. Nicole welcomes you to follow her on Twitter @NicoleSeghetti. The Motley Fool owns shares of Arcos Dorados, Apple, Annaly Capital, Intel, and Retail Opportunity Investments. Motley Fool newsletter services have recommended buying shares of Apple, Annaly Capital, Retail Opportunity Investments, and Intel, as well as creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (2) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2012, at 1:29 AM, TTPSRT4 wrote:

    Great article, especially for those of us who are "young and inexperienced" in the world that is Investing. I feel that I have established a well diversified portfolio in my short 6 months of real, actual investing. My current companies: Large Cap (BAC, GE, KFT, MSFT,WFC, WMT), Mid Cap (GSS, HOG, MNST), Small Cap (LL, MAKO, RST), International (BIDU, STV, IMAX, NXPI, SI). What do you think?

  • Report this Comment On September 18, 2012, at 7:58 AM, mikedever wrote:

    Diversification is extremely important and (in keeping with the the culinary theme of this article!) the one true "Free Lunch" of investing, meaning it can provide both greater returns and less risk than a portfolio that is not diversified. But true portfolio diversification cannot be achieved by simply spreading money across stocks. To truly diversify a portfolio it must be diversified across multiple, unrelated "Return Drivers." I describe this throughout my best-seller and am please to provide complimentary links to the following two chapters, where i discuss the lack of diversification from spreading money solely across stocks (including correlation tables), as well as the benefits of true portfolio diversification:

    http://bit.ly/utWsNy

    http://bit.ly/vxDo6v

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