In terms of investing and buying stocks, diversification is just a fancy way of saying “Don’t put all your eggs in one basket.” It’s one of the best ways to protect your investment portfolio from the many forms of risk. Diversifying your stock portfolio demands that you hold many different asset classes to spread the risk. (Assets are any items of value. An asset class is a group of similar assets.) With this strategy, a significant loss in any one investment or class doesn’t destroy your entire portfolio. More importantly, it ensures that in the event of a loss, you retain at least some capital to make future investments — and hopefully recover what you lost.
Analysts often use correlation to guide their diversification decisions. Correlation determines how closely two assets follow each other as they bounce up and down on the charts. Analysts measure correlation on a scale from 1 to –1. The number 1 represents perfect correlation, and –1 represents perfect inverse correlation. For instance, when oil prices rise, nearly all the oil companies rise together, achieving perfect or near perfect correlation. When oil rises 10 percent, but automobile companies lose 10 percent, their relationship represents perfect inverse correlation. A correlation of 0 (zero) means the rise and fall of any two sectors or stocks are unrelated.
To diversify, follow a process of asset allocation. Populate your portfolio with a variety of asset classes with different degrees of correlation, as described in the following list:
Stocks: Although stocks are considered an asset class of their own, the market offers several classes, including large cap, small cap, and foreign stocks, which allow you to diversify within the stock market. You can also diversify by industry — for example, consumer staples and telecoms.
Bonds: Fixed income instruments such as bonds have an inverse correlation to stocks. When stocks fall in price, investors often make a flight to safety by purchasing government-backed Treasury bonds. Greater demand for bonds moves their price higher. However, rising interest rates can hurt stocks and bonds simultaneously. Returns on bonds often increase as stock prices sink.
Commodities: Commodities are raw materials typically sold in bulk, including oil, gold, wheat, and livestock. In general, commodities have a zero correlation to stocks, meaning the risks that affect stocks have no bearing on what happens in the commodities markets.
Mutual Funds and ETFs (Exchange-Traded Funds): An easy way to diversify investments is to buy shares of a mutual fund or exchange-traded fund that holds a large basket of many different stocks or bonds. Instead of purchasing 100 shares of just one stock, you can get one ETF share comprised of 500 stocks without having to pay costly brokerage commissions.
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