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Diversification: Why It's Really That Important

By Matthew Frankel, CFP® - Mar 20, 2015 at 10:21AM

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No matter what stocks you choose to invest in, here's one investing rule you need to know.

Many investors underestimate the importance of diversification. And diversification (or a lack thereof) isn't always as obvious as many people think. For example, you can own 10 different stocks in very different sectors and industries and still not be properly diversified.

Here's what you need to know to give your own portfolio a diversification checkup.

Are your holdings diversified among different sectors?
Owning stocks in several different sectors is an important first step, so that if one sector does poorly, your entire portfolio won't suffer too much. Just imagine how you would have done this past year if most of your portfolio was in oil and gas stocks.

Now, this doesn't mean you need exposure to every sector. Even diversification isn't a good enough reason to buy stocks you're not comfortable with. For example, I don't know the healthcare and biotech industries well enough to comfortably pick individual stocks, so I don't own any of them. However, I have a pretty good spread among financial, tech, telecom, energy, real estate, and retail in my portfolio. This way, if, say, a tech crash occurs, I won't get wiped out.

Risk diversification
There's nothing wrong with owning some risky stocks. Speculation can definitely make you lots of money if things go your way, and let's face it -- taking a gamble on a potential home run can be quite a thrill.

However, you need to make sure you don't expose too much of your portfolio to high-risk stocks. The majority of your money, especially the money you're investing for retirement, should always be invested in stocks that are closer to the "sure thing" end of the spectrum.

For example, my investments in Cliffs Natural Resources and Transocean are very risky right now, which is why they make up a small portion of my portfolio. My positions in safer stocks such as Berkshire Hathaway and FedEx are much larger, and that's the way it should be.

Is your portfolio balanced?
To illustrate the importance of a balanced portfolio, consider a hypothetical portfolio consisting of $1,000 worth of five different stocks -- Apple, Wal-Mart, Wells Fargo, ExxonMobil, and Johnson & Johnson -- purchased in 2010.

AAPL Total Return Price Chart

Here's what the portfolio would look like today:

Company Symbol Original Investment 5-Year Total Return 2015 Value % of Portfolio
Apple AAPL $1,000 304.4% $4,044 36.5%
Wal-Mart WMT $1,000 71.3% $1,713 15.5%
Wells Fargo WFC $1,000 108.7% $2,087 18.8%
ExxonMobil XOM $1,000 42% $1,420 12.8%
Johnson & Johnson JNJ $1,000 82% $1,820 16.4%

Even though you spent the same amount on each stock, Apple now makes up more than 36% of this portfolio. The problem now is that if Apple were to have a bad year in 2015, your portfolio would get crushed, but if ExxonMobil has a great year, you'll barely notice any gains, since it makes up less than 13% of the portfolio.

When this happens, it's a good idea to unload some shares of the positions that performed the best and add to the underrepresented parts of your portfolio. This way, not only are your investments diversified across different sectors, but they represent a relatively even dollar amount of your portfolio as well.

Foreign and domestic
You also need to make sure you don't have too much exposure to any one geographical area, including the United States. In other words, you should have a significant amount of foreign exposure in your portfolio to protect yourself against currency fluctuations or a U.S. recession.

That doesn't mean you need to buy stocks of foreign companies. Many large U.S. companies do a substantial portion of their business overseas. For example, Procter & Gamble derives only 39% of its revenue from North America.

Another solution is to buy an ETF that focuses on international stocks, such as the Vanguard Total World Stock ETF. That way, economic issues in any one region of the world won't wreak too much havoc on your portfolio.

The importance of diversification
Different types of investments perform differently each year. According to a Wells Fargo Investment Institute report on the importance of diversification, 2014 investment performance ranged from a nearly 16% gain for equity REITs to a 17% loss for commodities.

Of course, it would be ideal to just pick the top sectors and countries each year, but that's not a very practical investment strategy. Your best bet is to have exposure to a variety of sectors, countries, and levels of risk, and over the long run you'll do just fine.

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