Diversification in Stock Portfolios

Topics: Investment, Modern portfolio theory, Mutual fund Pages: 5 (734 words) Published: February 2, 2014


Assignment No 6

Diversification in Stock Portfolios

Introduction

Diversification is one of the key components of a successful investment portfolio. Almost all

experts advise the avoidance of concentrating all of your investments in one type. However,

many investors forget about diversification once they see a financially attractive stock and

concentrate all of their assets in it. Other investors make a similar mistake and being influenced

by their emotions fail to listen to their common sense whispering "Diversify".

Many companies have attracted their employees to investing in company stock as part of their

retirement plan through the provided matching of contributions. As a result most investors end

up concentrating their assets in company stock and forgetting about the importance of

diversification. Investing in your company's stock is not something bad. However, you should

own not only your company's stock, because if something bad happens with your company you

risk not only losing your job but all of your assets. Through diversifying your stocks among

different industries you decrease to a great extent the risk of losing your money..

Portfolio Diversification

You can use index funds or exchange traded funds to track a broader market index. This gives

you exposure to many different types of companies, without your individual research required.

Furthermore, your money is allocated between many sectors, so if financial companies hit a

rough patch, perhaps your oil companies will be doing well.

. The most diversified funds will have exposure to the largest sectors of the US economy, and are

generally linked to a broad market index (like the Dow Jones or S&P). For diversification, stick

with the index funds, as they will incorporate a variety of company types.

Managing overall portfolio risk

The most general definition of investment risk is "return volatility through time." Asset

allocation is your most important decision when managing overall portfolio volatility. For

example, a measured blend of stocks (domestic and international), bonds and cash tends to

provide a higher level of return per unit of risk exposure than an all-stock portfolio.

Consequently, it's better to reduce the overall risk of an all-stock portfolio by allocating part of

the portfolio to bonds rather than by trying to invest only in less-volatile stocks.

Managing equity portfolio risk

After targeting your overall portfolio risk level via asset allocation, you can turn to managing

risk within your individual stock portfolio. The primary objective is to manage volatility relative

to your benchmark so that your stock portfolio generally moves with or "tracks" the stock

market.

In the previous article, we showed that a randomly selected portfolio of 40 stocks historically has

tracked the market with an annual standard deviation (a statistical measure of relative volatility)

of only 5.3%. Conversely, a five-stock portfolio historically tracked the market with a shocking

annual standard deviation of 23.8%!

To reduce relative risk, we suggest aligning your portfolio with your benchmark along the two

most critical dimensions of relative risk: company size and company sector.

Conclusion

You should be cautious when selecting your stocks because you may have chosen different

stocks and still have not achieved diversification. For example, you may select stocks of

companies that are highly related to one another and as a result a change in one of the industries

may affect the rest of them. In such a case it is said that the companies have a high degree of

correlation. Therefore, you should select companies not only from different industries, but also

companies that are influenced by different economic influences. An example of a...
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