Most experienced investors know it's a good idea to diversify your portfolio, because you don't want your money to be too sensitive to the performance of any single company or sector. Even if you really only care about tech companies, for example, you need to spread your money around to ensure that a sector-related collapse like we saw in 2000 with tech stocks doesn't wipe you out. However, once you properly diversify your portfolio, it requires some homework and regular maintenance to keep it that way.
What is a diverse portfolio?
A diverse portfolio fits two major characteristics. First, it doesn't have too few or too many stocks. If you only own two or three stocks, a bad quarter for one company can really hurt your account. On the other hand, if you own too many stocks -- say, 20 different companies -- you may as well simply put your money in index funds and save on trading commissions. A basket of five to 10 well-chosen stocks is a nice middle ground.
Secondly, a diverse portfolio doesn't have too much exposure to any single industry or to related industries. If you own six stocks, but three of them are highly dependent on the auto industry -- for example, General Motors, AutoZone, and CarMax -- your portfolio needs a change.
Your portfolio won't stay diverse forever
Once you're satisfied that your investments are sufficiently diverse, you still have work to do. Even though most investors know to diversify, the art of portfolio reallocation is not discussed nearly enough.
If you have a 401(k) at work, this is already done for you. Generally, when you sign up, you specify what percentage of your assets you want invested in certain funds (e.g., 25% in an S&P 500 tracker, 20% in small caps, 10% in bonds, etc.). Well, if the stock market skyrockets, your shares of the S&P index fund will represent more than 25% of your portfolio, as it will disproportionately increase in value relative to bonds. Your plan administrator will automatically sell some of your shares to keep the percentages as you specified.
Let's say you buy five stocks and invest an equal dollar amount into each one. Well, as we all know, different stocks perform differently, so after a year you might not have equal holdings in one company. For example, if you had invested in Tesla a year ago, it stock would now represent much more than 20% of your portfolio, having soared 273% in that time.
Or let's say you bought equal dollar amounts of five stocks in 2003, and one of them happened to be Apple. Well, Apple is now worth more than 60 times what it was back then, so it could easily represent the majority of that portfolio. If one of the other companies doubles, you'll barely notice. The same is true of your losing positions. If you had put 20% of your money in Citigroup in 2005, it's certainly not 20% of your portfolio now. Reallocating your money will allow you to better capitalize if the share price begins to recover.
Consider this example of a diverse $10,000 portfolio of five stocks purchased a year ago (with each stock starting at 20% of the total). Notice how their allocations would have changed as a result of their performance.
|Company||May 2013 Price||May 2014 Price|
|Bank of America||$12.39||$15.08|
Because this will inevitably happen to your investments, you need to spend some time every so often (once a year is good) to rebalance your portfolio. In the above example, the portfolio has grown a little too dependent on Apple and not dependent enough on the performance of Target.
Why it's important
This is important for two main reasons. First, it forces you to lock in your gains. In the above example, we would have to sell off about 17% of our Apple stock in order to bring it down to just one-fifth of the portfolio. When we do this, we're taking our Apple profits, which are now ours to reinvest, and now our portfolio isn't as vulnerable if Apple goes back down. In fact, if we sold some of our Apple stock now, and it happened to go all the way back down to $450, we'd still be ahead.
Rebalancing also lets you capitalize on rebounds in losers. Target lost about 15% of its value over the last year due to its infamous data breach and some less-than-stellar financial results. However, these are temporary issues, and if we believe in the company for the long term (as you should with every stock you own), we are betting it will rebound eventually. Well, if we bring our allocation in Target back to 20% of the portfolio, we stand to gain much more if shares return to their previous levels.
As I said before, once a year is a good interval for reallocating your portfolio. It's definitely worth spending a couple of hours once a year to lock in gains, double down on cheaper companies, and spread your risk around, and this is especially true if you've had any big winners or losers in your portfolio.
9 of the best stocks to build a diverse portfolio
The smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Apple, Bank of America, CarMax, General Motors, and Tesla Motors. The Motley Fool owns shares of Apple, Bank of America, CarMax, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.