Diversification in your stock trading portfolio can mean different things to different types of investors, or even to the same investor at different trading times. But it always describes the concept of spreading out your investments instead of “putting all your eggs in one basket” which might be a single national market, a single asset class or even a single stock. Here are some ways to accomplish this:
- Diversification by risk. This is where many traders and active investors learn to focus in the investment classes at Online Trading Academy. If you are interested in greater returns, risk is good because it translates to potential rewards. The economies of the U.S., Europe and emerging nations behave very differently and so do their stocks; if the U.S. markets are flat, an equities investor might look overseas for more volatility.
- Diversification by balance of current income and long term wealth potential. This is the focus of our ProActive Investor curriculum at Online Trading Academy. Investors use our patented supply and demand trading strategy to find opportunities to build significant wealth for the future. At the same time, they use options strategies such as covered calls to generate current income at relatively low risk.
- Diversification by asset class. The major stock markets are highly liquid and easily accessible to any investor. Forex trading provides rapidly changing opportunities around the clock simply by following the price movement of currency pairs. Futures trading lets investors bet on how a drought will affect the price of wheat, or Mideast conflict the price of gold. And options trading allows sophisticated traders earn significant income on a relatively small investment. An educated investor might combine these asset classes to enjoy all their benefits, instead of focusing on just one of them.
- Diversification of growth vs. income assets. This is a more traditional variation of strategy #2, and quite popular with everyday investors. Growth stocks are new companies or companies in growing industries that pay small or no dividends because they are putting all their money into growing their business (and so their share price). Income stocks may have minimal share price fluctuation, but they pay dividends that might add up to 4-5% or more of the share price each year. As retail investors get closer to retirement age they might add fixed income to the mix: bonds and U.S. Treasury bills that pay less income than dividend stocks, but are more predictable (at least until recently) because of the underlying asset.
And why should you diversify your portfolio in the first place? Diversification gives you the potential of making more money while avoiding surprises that can wipe out your portfolio. A well diversified portfolio will have low correlation among its component categories—meaning their prices don’t all move in the same direction. In other words, one category may be appreciating and another slumping at any point in time.
If you’re an active investor you can monitor this process, and shift your portfolio to take advantage of market conditions. Even if you have someone else manage your wealth, you should still review your holdings on a periodic basis and see if you are satisfied with the performance of your investments or if your portfolio needs rebalancing.
One thing that isn’t diversification is owning multiple stocks in a single industry, and thinking you are insulated against risk. This is a common and often costly mistake. Stocks in an industry tend to move in lock step: if one reports a negative earnings surprise, all of them will go down in price even if the other companies have healthy earnings.
You can find out more about diversification, and how to do it, starting with a free Power Trading Workshop at Online Trading Academy. Classes are held on a regular basis at our local financial education centers and online. Complimentary registration for an upcoming class is available here.