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The Truth About Stock Market Diversification |
Many investors believe that by buying a variety of different stocks that they are actually spreading out their risk. Diversification is the active investing in more than one stock. The theory behind diversification is that if one stock fails then you will still have the others to fall back on.
Many investors believe that by buying a variety of different stocks that they are actually spreading their risk. Diversification is the act of investing in more than one stock. The theory behind diversification is that if one stock fails then you will still have the others to fall back on.
In theory stock market diversification is extremely logical and on the surface it makes sense. Regardless of how accurate analysts may become at stock market timing they will never be 100% accurate. If any of us could be 100% accurate in our stock picks then we would not need to diversify, we would simply invest all our money in our very best stock pick.
It is quite obvious that none of us has a crystal ball and can pick stocks with 100% accuracy. Because of the uncertainty involved in any investment strategy we understand that we must control our risk. For most investors diversification is the most likely solution.
Before you embark upon buying a variety of stocks simply to be diversified it makes sense to ask yourself a very important question. "Have I truly controlled my risk by buying a variety of stocks?"
Let's look at an example and see if that is actually the case. If you buy Ford, Chrysler, and GM stock you may believe that you are diversified. The fact is you are diversified in the strictest sense of the word. Unfortunately because these are all automotive stocks you are not necessarily controlling your risk. If on the other hand you purchased an automotive stock, an oil stock, and a retail stock you would be doing a better job of controlling your overall risk in your portfolio.
What we've touched upon has been very basic and is meant to serve more as an eye opener than as a hard and fast guide. It's a good idea to adequately review your portfolio with your financial advisor to make certain that you are truly diversified in your stock holdings.
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