Diversification

    Diversification is a nice lofty term but what are the considerations and mechanics that make it work? We've all heard "don't put all your eggs in one basket." It's a good maxim, but there's more to it. Can you be overly diversified? Let's take a look at the concept of diversification. The purpose of diversification is to reduce the negative impact that a single or group of stocks can have on the value of your portfolio. Sure, we all would love to have every dollar we can lay our hands on in one of the stocks we see jump 40 percent in a single trading day or that runs up a hundred percent in a week. But for every time a stock jumps up like that there are five stocks that drop 20 percent of their value in a single day. Over the past handful of months we've seen the market respond mercilessly to stocks missing their earnings forecast or warning of less than stellar earnings. The response was stock values that declined 30, 40 or even 50 percent in a single day. People holding shares in those companies when the stocks dropped like a rock got crushed. How do you protect yourself? If you're holding your entire portfolio in one of those stocks when they issue what is perceived as bad news, you've just taken a 30 percent hit. Ugh!! If you had only half your portfolio in the stock you took a 15 percent hit. One third of your portfolio in this destitute stock and you lost 10 percent. One forth of your portfolio in the unfortunate stock and you're only off 7.5 percent; a fifth of your portfolio in the stock and you're only taking a 6 percent hit. Now most of us can handle losing 6 percent over night. A 6 percent loss is certainly more palatable than a 30 percent loss. A 6 percent loss only takes a 6.5 percent gain to be even, where a 30 percent loss takes a hefty 43 percent gain to just get back to even. Think about it, if you are using a 10 percent stop loss limit on each trade you make why should you accept a larger risk in the off chance a negative press release comes out on a stock you hold. You need to watch your percentage exposure to a single stock.

    Can you be over diversified? If you extend the logic stated previously, in the example, you would only take a one percent hit if you owned 30 stocks in your portfolio. You'd take just half of one percent hit if you owned 60 stocks in your portfolio when the bad news comes out on a company you're holding. But can you keep track of 60 stocks? Some investors can and others would lose more money juggling or losing track of them. If you're attempting to buy stocks at the lowest possible price and sell them at the highest possible price, that gets to be unwieldy for most investors if they are holding 30 or 60 stocks. Depending on the commissions you pay the cost of entering and exiting 30 or 60 stocks could far outweigh the benefit of not holding just 5 or 10 stocks. Many sectors move in tandem so diversification also has to take into consideration the make up of the stocks in the portfolio. Technology and Internet stocks are most likely to give you the best return when these sectors are hot, but watch out when they're having a bad day. You even need to consider what exchange a stock trades on. Look back at the shifting in and out of blue chip and technology stocks we've seen during the year. One day money flows out of the NASDAQ and into the NYSE, and a day or two later the tide flows back the other direction. Only you know how much risk you are willing to take and only you know the appropriate number of stocks to hold. In reality if you're 100 percent in cash and you see a stock you want to own you should only commit 20 or 25 percent of your capital to that one position. This takes more discipline than most investors have.