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The Importance of Diversification
We’ve all heard the term “Don’t put all your eggs in one basket.” One slip and
fall and all the eggs in that particular basket could break. Placing the eggs
in more than one basket mitigates the effect of the fall of one basket. The
saying seems sensible and logical.
The same philosophy applies to investing. We need look no further than Enron
and MCI to realize that anyone with all their assets in one of those companies
experienced severe losses.
Diversification, or spreading your wealth over an array of companies or
investment vehicles helps to mitigate the potential of catastrophic (or
mundane) losses associated with a single investment. Current investment theory
suggest that a portfolio of 15 to 17 investment securities of companies that
operate in different product markets in different business cycles removes or
reduces the effect of the price movement of a single security.
The different investment securities in a diversified portfolio might include
fixed income securities as well as a diversified holding of common stock.
Market theory also suggests that holding cash or money market securities in a
portfolio dampens portfolio volatility, and cash in that sense is treated as an
investment security.
A diversified portfolio might include several of your favorite stocks, a few
tracking stocks (like the QQQ, DIA or SPY) to participate in market segments
that are not represented by your list of individual stocks, and perhaps a
closed-end bond fund for fixed income market participation.
It is important to remember that even a well diversified portfolio is not immune
to losses as markets fluctuate. A well-diversified portfolio helps us weather
market storms.
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