Starting With Diversification

Staring at the blank page before you
Open up that dirty window
Let the sun illuminate the words that you could not find
--Natasha Beddingfield

Suppose that you are new to investing and you're interested in investing in stocks. You have a modest sum to invest. Like anyone, you'd like to 'make money' on your investments right away. However, your primary goal is to learn how to go about investing in stocks in a manner that will help you achieve financial goals over the long haul.

Here's one way to start. Take the amount of money that you'd like to allocate to stocks and divide it into 4-5 equal portions. If you have $2000 to invest, then it can be divided into 4-5 portions worth $4-500 each. These are the slots, or 'positions,' that you want to fill with stocks.

How to best fill those positions? You may have some ideas already. While thinking about the possibilities, keep in mind an important investment principle known as diversification. You're probably familiar with the saying, "Don't put all your eggs in one basket." A single basket of eggs is risky. Lose it or drop it and all your eggs are gone. Same thing with investing. Although investing all of your funds in a single stock that you love might seem like a sure thing, the future is never sure. Making a concentrated bet leaves you vulnerable to large losses in the event that your investment does not turn out the way you foresee.

Diversification means that you spread risk over a variety of choices, conceptually placing your investment eggs in different baskets so that you're not overly exposed to a particular idea. You've already started the diversification process by establishing those 4-5 slots noted above. This forces you to distribute your investment capital among various stocks.

You should also consider the degree of diversity among your stock picks. Price movements of stocks in similar businesses are often correlated, meaning that they tend to move up and down together. For instance, the prices of bank stocks like Bank of America (BAC) and Wells Fargo (WFC) exhibit significant correlation. Correlation is the enemy of diversification. You can invest in stocks of various companies but if the prices are highly correlated, then you have essentially constructed a portfolio that behaves like a single stock.

In addition to establishing a portfolio with several positions, you can do even better from a diversification standpoint by spreading your stock picks among various industries or sectors. Stocks from different sectors tend to be less correlated. While there are many ways to categorize industry sectors, here is a simple list to consider (in no particular order) when starting out:

Consumer products (consumer products makers)
Retail (brick and mortar stores, on-line sellers)
Healthcare (pharma, medical devices, health insurance)
Technology (computers, software, info services, emerging tech sectors)
Media/Entertainment (traditional media (TV/cable networks, newspapers, social media, media distribution)
Energy (fossil fuel production, refining, distribution, alternative/green energy)
Industrial (basic manufacturing (e.g., autos, chemicals, mining), transportation providers (e.g., trucking, trains, planes))
Utilities (power and heat source generators/distributors)
Telecom (phone, cable, internet service providers)
Finance (banks, brokers, insurance)

The idea is to find candidates from 4-5 of the above sectors to start your stock portfolio. How to identify and research candidates? Stay tuned...

position in WFC