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Pencils Palace
Why Diversification is Key in a Portfolio

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By pencils2
May 16, 2006

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Hi all,

On another lazy Sunday here in California I thought I'd write a little bit on diversification and why it is absolutely key for a winning portfolio.

What is diversification? Diversification in the stock market is being invested in several sectors and industries that aren't related to one another (In a big way). But don't invest in a sector you are not comfortable with. For instance, I am invested in restaurants, technology, Internet, coffee, tools, mining, and India. But the percentage is what is important. You could have $2000 invested in tools and coffee while your other $98,000 is invested in technology and the Internet. Diversification among sectors and industries can be done many ways - You can buy an index fund or mutual fund for a particular sector or industry, or you can invest in individual companies from particular sectors/industries. As long as you are not "over-weighted" (Having a higher-than-normal amount invested in a sector/industry), you will be fine.

Why diversify? Ask people from the 1990's. During the 1990's, day trading was at its height, as was "un-diversifying." People were only buying into tech and Internet stocks, no matter how outrageous it was. An example: Juno announced it was going to make all of its products free, and was no longer going to make a profit. You'd think the price would go down, but it actually quadrupled in two days from $16 to $64. The crash came when it always does (And always will), at the end of a bull market where investors forget about evaluation and pushed stocks up to heights that weren't supported by earnings. The only reason people got hit so hard is because they weren't diversified. If people had treated tech stocks with the same, equal investment amount as their other positions, they wouldn't have been hit so hard. This is why diversification is key, no matter what the market is doing.

This brings up another point. There are always opportunities in the stock market, whether you are in a bull market (Don't get carried away investing in companies with no earnings), a flat market, or a bear market. It doesn't matter what is going on during a specific time span, such as the war in Iraq today. There are still plenty of opportunities in the stock market. Again, this is why diversification is key, because you never no what the market will do. Just because gold goes down doesn't mean retail will, just because technology has a tough time doesn't mean the beverage industry will have a tough time, and so on and so forth. I believe diversification is key for a successful long-term portfolio, because as I said before, you never know what the market, world, or economy is going to throw at you.

I've only mentioned diversifying among sectors and industries, but diversifying among different sized stocks is another excellent idea. For instance, if you want a high risk/reward ratio with a beverage company, you wouldn't pick Coca Cola. You'd pick Hansen or Jones Soda, depending on which one fits your investment style. So, try to also diversify in micro-caps, small-caps, mid-caps, large-caps, and blue chips (Huge, well known companies such as Coca Cola). But, it also depends on the amount of risk you are willing to take. If you are 50 and planning to retire in 10 years, it wouldn't be the best idea to invest in too many small or micro-cap companies, buying mid-caps, large-caps, and blue chips would be the best idea.

Diversifying among countries is an option I see as a good one, but certainly not one you have to use. But, China could certainly give some great returns in the long run, along with several other countries. This is where an index fund may be your best bet, unless you feel comfortable picking individual stocks (Or ADRs, which are foreign companies traded on an American exchange) from a foreign country. Again, it all depends on how much risk you are willing to take with your investments.

And one more thing that doesn't involve you and your portfolio, which is "deworsifying," a term brought up by Peter Lynch in One Up On Wall Street. Deworsifying is when a corporation purchases or partners with a company that is not at all related to its line of business. When Johnson & Johnson goes into the funeral home business, that is deworsification. When a company deworsifies it is usually a sign that it will do anything to get some growth (i.e. money). This hurts the business, makes it harder to run the company (If you see a corporation by another corporation that isn't related to its business, how can you successfully run a business that you have no experience with), and will eventually send the stock price down. I highly recommend One Up On Wall Street (Which the Fool says is the greatest book ever written on investing) for more information.

So, make sure your companies are deworsifying while you are diversified among sectors, industries, countries (This isn't absolutely key, but it is certainly a good option), and different sized companies. Over the long-term your results will be very satisfying. Remember to only invest in companies/countries/industries that you are comfortable with. You want to feel very comfortable with all of your investments when you purchase them, and hopefully you always will!

Best,

David K


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