Just about every stockbroker, financial advisor or money manager worth their weight in salt knows that diversification is a major way to us to manage investment risk.
But here's what most -- professionals and retail investors alike fail to remember: Diversification doesn't just mean choosing to invest in different companies that do different things and that's it. Creating real diversity and ultimately protecting your investment portfolio involves a little more work, which amazingly, most professionals still get wrong.
Here's the one step that almost everyone misses...
The Tricks of the Diversification Trade
Sectors -- The oldest and most common method of diversifying your investment portfolio is by choosing stocks in different sectors. Sector diversification might look something like portioning your investments with 20% in financials... 20% in energy... 20% in retail... 20% in commodities... and maybe 20% in consumer-related stocks. This is just an example..
While the sector method may work, what if financials, commodities and energy are all highly correlated? Then you might have the majority of your account moving in tandem both up and down. In bullish times, that may be great... but when things go wrong are you protected?
Cyclical & Defensive -- Another method is to adjust and balance your accounts based on the type of stock it is , and its sensitivity to the economy. I agree with this method as well. The defensive names like Johnson & Johnson (JNJ:NYSE), Altria (MO:NYSE), Diageo (DEO:NYSE) and Proctor and Gamble (PG:NYSE) can be quite boring when the market is moving higher lower, these names can move lower as well. But they likely won't move down as far as other companies. (That's a hint to the secret!)
Growth Companies & Established Dividend Payers -- Both of these types of companies should be incorporated in your portfolio -- at the right times. Finding solid, established dividend-earners when stocks have been beaten up can offer you great yields. Growth companies can give you more of a leveraged exposure, perhaps amplifying your returns when they are bought at the right time.
All of these types of diversification are acceptable and should be considered. However, just because you are diversified using these methods doesn't mean that you are not going to feel the effects of a bear market if you don't employ this one tactic...
BETA (Portfolio Beta) -- You wouldn't believe how many investors overlook this one simple measurement. The "beta" of a stock tells us how the stock tends to react when the broad market is moving. Think about beta as a gauge of how sensitive your stock is to a bullish or bearish move in the market. It is an integral step if you want to truly diversify and balance your portfolio.
Beta = Relationship stock has to its underlying index
Beta of 1 means that if the index is up 1%, the stock will most likely be up 1%
Beta of 2 means that if the index is up 1%, the stock will most likely be up 2%
Beta of 0 means minimal correlation
Beta of -1 means that if the index is up 1%, the stock will most likely be down 1%
I put a large amount of credence into beta and combine it with other methods when I am looking to truly diversify. Even if you have a bunch of stocks in a bunch of different sectors, ifthe majority of them have a beta of 2-3, you have some serious exposure to market downturns, no matter the.
Finding Your Portfolio Beta
Some brokers actually offer tools that allow you to see your total investment portfolio's beta. But for those of you like me who want to know the math:
1.Simply find the betas for all your stocks
2.Multiply the stock's beta by the percentage of your total portfolio that stock represents
A stock with a beta of 2 that is 5% of your portfolio would have a weighted beta of .10 (2 X .05)
3.Add all the weighted betas together to arrive at your portfolio's overall beta
Be sure that you look at all of these factors if you are truly trying to diversify and minimize risk in your portfolio. If your portfolio beta is over 1, you are amplifying any moves the overall market makes.
P.S. If you want to learn more about beta, risk, volatility and some really amazing domestic and international strategies, we have made the audio recordings from our Las Vegas Summit available to the public. You can hear my presentation, plus all of our other esteemed editor's thoughts, on these MP3 and CD recordings.
By Jared Levy
Jared Levy is Co-Editor of Smart Investing Daily, a free e-letter dedicated to guiding investors through the world of finance in order to make smart investing decisions. His passion is teaching the public how to successfully trade and invest while keeping risk low.
Jared has spent the past 15 years of his career in the finance and options industry, working as a retail money manager, a floor specialist for Fortune 1000 companies, and most recently a senior derivatives strategist. He was one of the Philadelphia Stock Exchange's youngest-ever members to become a market maker on three major U.S. exchanges.
He has been featured in several industry publications and won an Emmy for his daily video "Trader Cast." Jared serves as a CNBC Fast Money contributor and has appeared on Bloomberg, Fox Business, CNN Radio, Wall Street Journal radio and is regularly quoted by Reuters, The Wall Street Journal and Yahoo! Finance, among other publications.
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