Stock market investments – Importance of diversification

Diversification is a stock market investments technique in which the investor reduces his risk by allocating his investments in more than one stock bond of any other financial instruments. With diversification, he reduces the risk of loosing money in case his preferred stock has taken a beating or when a specific sector is not doing well.

There are two types of risks involved while investing in stock market. One is called undiversifiable risk which cannot be avoided. It is also called systematic risk or a market risk. Examples of this risk types are inflation, political unrest, economical instability, war, exchange rates etc. There is no control on these risks therefore they are called undiversifiable risks. Other type of risk is called diversifiable risk. This risk is associated with a particular stock, sector, economy or even a country. This risk is also known as unsystematic risk and can be mitigated using technique called diversification. The way it can be mitigated is by diversifying your portfolio by investing in different stocks, sectors and economies.

Let us take an example to prove that diversification works. Let’s say that you buy stock only from auto sector and they have been giving you nice results. But suddenly there is news that labor union of major auto companies have called for a strike. This would definitely bring down the share prices of auto companies since it would affect their bottom line. And you will see drop in your portfolio. Therefore, it is important to put some money is other unrelated sectors which would not get affected by same news. The more unrelated companies are the better diversification is. Most investors who are beginners in stock investing prefer to diversify by buying bonds.

How many stocks should I have?

This is a common question which investors ask when they are told to diversify. Obviously 5 stocks are better than one to reduce risk. While there is no rule around that, experts say that having a portfolio of around 15 to 20 stocks in varying sectors can make a good portfolio. Depending upon the risk appetite, these stocks can be blue chips, mid caps or even penny stock investments.

While diversification doesn’t guarantee that there would be no losses, it has proved to reduce the losses. Most people would use an asset allocation toll which would help them allocate their stock market investments. This toll is pretty useful for beginners who are new to stock market. It would generally ask a few questions which would help it know your age, risk appetite, investment horizons and a few more parameters. After that, it would suggest you how you should allocate your investments. What percentage should go to stocks, bonds, real estate, fixed deposits etc? It is a very handy tool especially for beginners in stock market and young investors.

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