May 12th, 2008
Working Backwards: What’s Diversification?
Diversification is a way of reducing risk in your portfolio. In broad investing terms, diversification means to own a small amount of many different stocks rather than a large amount of just a few. Owning a portfolio with 100% of your money in a single stock poses far greater risk than having 1% of your money in each of 100 stocks.
Research has shown that the majority of risk reduction from diversification occurs with a portfolio of approximately 25-30 stocks. Further diversification can reduce risk even more but with diminishing effectiveness. It is difficult for an individual investor, particularly one who is just starting out, to diversify by buying many different individual stocks. Fortunately, today, an investor can easily diversify by buying a mutual fund or exchange traded fund.
Besides diversifying within the domestic stock market, it’s also quite possible for an investor to diversify in international stocks and in bonds, also by purchasing appropriate mutual funds or exchange traded funds. As we complete our Total Stock Makeover II mini series, we will look at three different funds which give diversification within the domestic and international stock markets as well as the high quality bond market.
