The stock market has been hitting new highs. If you’re an investor, that might be sending mixed signals. On the one hand, a rising stock market is good for stock market investments. On the other, a strong market might scare investors afraid of a fall. The Great Recession of showed markets can pull back sharply.
Over time, though, buying stock is a good investment. The stock market may have down individual years, but over the last eight decades, investors have overall made solid returns.
Most advisors will tell you it’s wise to diversify your portfolio. Diversification means you have enough different types of investments that not all of them rise or fall at the same time. Here are some tips on making sure your portfolio is diversified.
1. Allocate your portfolio between stocks and bonds
In stocks, you are buying partial ownership of a company. The fortunes of your stock will likely depend on the company’s success in building markets, selling its products and achieving profitability.
When you buy a bond, you are purchasing a debt instrument. The payoff you receive is part of the service on the debt paid by governments or corporations. Bonds are also yield instruments. What you expect is not price appreciation but interest.
It’s wise to divide portfolios between stocks and bonds, because bonds usually guarantee a steady yield and don’t move in tandem with the stock market. The precise allocation depends on your comfort with risk and your time. Stocks carry more risk than bonds.
2. Diversify between Consumer Defensive and Consumer Cyclicals
One thing to take into account when deciding which stocks to invest in is what economic conditions the companies will do well in. Consumer Defensives can do well in a variety of environments. Why? Because they are companies whose products consumers need regardless of whether the economy is strong, average or weak. People purchase healthcare products, groceries, household supplies and personal care products regardless of economic conditions.
Consumer Cyclicals produce more expensive goods that are not necessities. Automobile, housing, entertainment and retail businesses may be hurt by an economic downturn, as consumers rein in spending. Diversifying your portfolio among both will ensure economic conditions don’t impact you as much.
3. Know the strengths of sectors
It’s prudent to diversify among sectors as well. Technology stocks, for example, can be volatile because the area is volatile, with some chance of businesses becoming superseded by nimbler startups with newer technologies. Think Snapchat taking market share from Facebook.
Other industries have different concerns. The oil companies are affected by the price of oil versus the price of its extraction from the ground. Oil company analysts need to know the difference between working and royalty interests. Utilities, on the other hand, are steady and can return high yields year after year, partly because they have little competition in their markets.
4. Purchase some stocks with dividend yields
Although stock investors primarily benefit financially from stock price appreciation, they can also see gains from dividend yield. A dividend is a defined amount companies decide to pass on to their investors. Dividends are usually paid every quarter. The yield is the percentage return investors receive.
Dividend yield continues whether the stock price goes up or down. As a result, buying dividend stocks can protect investors from stock market dips, because they will still make money on the yields. Smaller companies in innovative sectors like technology seldom pay dividends. Consumer defensives, utilities, oil and real estate investment trusts often pay robust dividends.
5. Buy funds composed of many stocks
One of the simplest strategies to achieve diversification is to purchase baskets of stocks rather than relying on individual stock-picking prowess. Baskets can be mutual funds based on either stock market indexes like the Standard & Poor’s 500 or on a sector. There are also mutual funds based on commodities, such as oil or gold.
Some baskets are exchange-traded funds (ETFs) in a specialized index, such as all companies engaged in solar power. The advantage of all these funds is they follow a number of stocks. Thus if the performance of one stock is hit by a specific issue, the performance of the others can smooth that out.
6. Beware of over-diversification
While diversification is an excellent strategy, it is possible to go too far in that direction. Many observers recommend an investor hold between 20 and 30 stocks, but no more than 30.
Managing your portfolio can become time-consuming if you own more. Transaction costs can grow burdensome if there are more, as buying and selling both are subject to expenses. Investors should also factor in their time researching and thinking through stocks to buy. There can be a time versus financial benefit trade-off that tips in the negative direction if one simply has too many stocks.
Want to invest in multiple companies across different industries? That’s a wise plan. Diversified portfolios can position you to gain if the stock market rises and protect you when it falls. These tips will help you achieve maximum diversification.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
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