How to Minimize Your Risk by Diversifying Your Stock Investments
Diversification is a strategy for reducing stock risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments? The easiest way to understand proper diversification may be to look at what you shouldn’t do:
Don’t put all your money in one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks.
As a general rule, the money you tie up in a single stock should be money you can do without.
Don’t put all your money in one industry. Some people own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it can work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt.
Don’t put all your money in one type of investment. Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio.
Some of these alternatives can be found in mutual funds or exchange-traded funds (ETFs). An exchange-traded fund is a fund with a fixed portfolio of stocks or other securities that tracks a particular index but is traded like a stock.
Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice:
Keep only 5 to 10 percent (or less) of your investment money in a single stock. Because you want adequate diversification, you don’t want overexposure to a single stock. Aggressive investors can certainly go for 10 percent or even higher, but conservative investors are better off at 5 percent or less.
Invest in four or five (and no more than ten) different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand.
To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities.