Diversification

Diversification is crucial to building a long-lasting portfolio. Just like in most team-based sports, we must build a solid defense against potential attacks. In this case, diversification can help us stay invested in the market when we otherwise would have cashed out. Diversification also helps us remain disciplined during times when the market seems to be going up every single day.

Maybe you own some bonds, real estate, stocks, cash, or even some crypto currencies as part of your investment mix. There are many ways to diversify within each of these asset classes as well as across them. There are almost endless combinations that can provide for a well-structured diversification strategy. I will not go into all of them because I would bore you to tears. Frankly, there are many books on this subject alone. You can spend months trying to learn all the different diversification strategies out there. I found this article from Fidelity to be a great starting point, https://www.fidelity.com/viewpoints/guide-to-diversification if you like to learn more. Here, we are going to focus on stocks only. I will assume you will work with a financial advisor to set up your asset class diversification.

The most common way to diversify in stocks is by spreading your holdings among different industries and sectors. Fidelity classifies each sector as follows:

Others may use only ten sectors, but I prefer to use twelve instead. It gives us a better view of how the market is categorized. The more you spread your holdings across these sectors and industries, in theory, the greater diversification you will have. Simple right? Not so fast. Some of these sectors trade together. Thus, minimizing your diversification and increasing risk.

The way I prefer to diversify is to look for different industries and sectors that are not correlated to one another. You may visit one of the websites I recommended on my previous post titled “Where can I research stocks?” Yahoo Finance or any other similar service can provide you with historical data to figure out past sector correlations. In there, you can see that certain sectors trade together depending on which part of the economic cycle we find ourselves in. If things are not so good, consumer staples, utilities, and health care stocks may do well during this time. If the economy is doing well, we will see technology, industrials, and consumer discretionary trade up.

If there is no systemic risk, like the latest downturn in 2008, stocks will go through these rotations, adjusting themselves to what works during each season. If you have a portfolio full of tech stocks during a boom period, you will take a huge hit when the market rotates out of technology into utilities and consumer staples. Therefore, it is important that you choose stocks from each sector and rebalance every quarter or a couple of times a year.

Now that we have gone through the way I like to diversify my stock portfolio, we can meet next time to speak about how I go about choosing stocks in each one of these sectors and industries. I want you to do the work for yourself, use this as a simple guide to help you find the right diversification style that fits your risk tolerance.