Top Investment Strategy: Make
Sure You Are Diversified
Monday, August 29th, 2011
By George Leong, B.Comm. for Profit Confidential
Diversification is the key to success in the stock market, especially given the current negative bias. Whether you buy or short, or add put and call options, the key is akin to being a good pitcher—mix them up and you increase your chances of success.
The reality is that it doesn’t matter if you are investing in the real estate market, gold, stocks, art, or antique cars; the best way to protect your wealth is not to put all your eggs into one basket. This is obvious, but I’m surprised at how few investors actually follow this.
Would you load up on all technology stocks? Going back to the baseball analogy, can you imagine a pitcher throwing just a straight fastball? Eventually it will be hit hard.
The end goal is to make money and longevity. The longer you are in the business of investing in the stock market, the more experience and opportunities you will gain.
Think about investing this way: when you are buying a stock, you are investing in a business. The people who run that business are entrepreneurs, looking to generate a return on the capital their company invests. The people who provide this capital are investors—people like you. You invest your capital because you are looking to generate a decent return on your investment.
Naturally, if you are going to invest your money in a business, you want to have some say in how it is run, in order to protect your investment. In the stock market, however, you don’t have that luxury.
You can vote for company management or some specific initiatives, but you can’t actually participate in the company’s daily decision-making. So, this means that you do not have control over a company’s ability to allocate your capital. Therefore, the only option available to you as an individual investor in the stock market is to spread your investment capital around. You need to divide your own investment risk among a number of companies, because you can’t control the actions of a single one of these entrepreneurs.
The concept of spreading your investment risk is called portfolio management—a process that encompasses the creation, monitoring, and adjustment of your investments. This process never stops, because you are continually buying and selling new stocks. Taking a “portfolio approach” to your stock market investments helps you stay in the game longer and improve your returns.
Taking a portfolio approach to your stock market holdings means diversifying the industries in which you invest. Not only do you need to spread your investment capital around a number of different stocks, but you also need to diversify your holdings across different industries. Owning a basket of stocks in one market sector increases your investment risk substantially, so you have to spread your money around different sectors if you want to protect your wealth over the long term.
In the current environment of uncertainty, you can buy selectively on weakness, but also play the downside via put options or, if you’re aggressive and experienced, take a look at shorting.