As a senior in high school, your guidance counselor probably advised you to apply to five or six colleges. Similarly, if you are planning on working after graduating from Duke, you are probably going to apply to more than one company for a job.
The same advice holds true when making investment decisions. It is important not to concentrate your portfolio in any one investment. Just as you would not want to face the consequences of not getting into the only college to which you applied, you do not want to risk your capital in only one investment.
The investment principle behind spreading your money across numerous stocks is known as diversification. Diversification will prevent any one poorly performing stock from ruining the performance of a portfolio. For example, say you invested $1,000 in each of ten stocks. If the value of one stock declines by 50 percent (was worth $1,000 but now worth only $500) and the other nine remain unchanged (still worth $9,000), your portfolio has declined by only $500, or 5 percent.
Now, if you had invested in only five stocks, and were unfortunate enough to buy the stock that declines by 50 percent, therefore losing $1,000, your portfolio would have lost 10 percent of its value. By diversifying, you were able to reduce your losses by half.
Diversification is one of the main reasons that I recommended buying mutual funds. Because many students do not have enough money to buy the 15 to 20 stocks required for a diversified portfolio, mutual funds can provide the necessary diversification. By combining your money with other investors, the fund manager can buy enough stocks so that no single stock can greatly influence the performance of the portfolio.
Although individual mutual funds generally are well-diversified, you can gain even greater diversification by buying various mutual funds. A well-diversified portfolio of mutual funds should include both domestic and international funds, as well as both large capitalization and small capitalization funds.
Capitalization refers to the total dollar value of stock a company has outstanding and is used to differentiate large companies such as IBM from small companies such as Trimble Navigation, a relatively unknown maker of satellite receivers. Whereas IBM has a market capitalization of over $100 billion, the total value of Trimble's stock is only around $200 million.
By diversifying, you reduce the guesswork in trying to pick the best type of mutual fund. Under certain conditions, large company stocks will outperform smaller stocks, or domestic stocks may outperform foreign stock funds. It is very difficult, however, to predict when this will happen.
By selecting a well diversified group of mutual funds you will get some top performing types of funds, but you will also get some that do not perform quite as well. In the end, your aggregate performance will be somewhere between the best performer and the worst. Remember, though, that the reason to diversify is because you want to avoid the worst outcome.
Diversification is important, but its benefits have limits. Whereas a portfolio of five to eight mutual funds is well-diversified, a portfolio of 15 funds is over-diversified.
At this point, you are almost guaranteeing yourself average returns and will minimize the chance that any one fund will contribute a significant gain. What it comes down to is how much risk you are willing to take. By choosing fewer investments, this increased chance of exceptional performance only comes at a greater risk of loss.
In recent months, the advantages of diversification have been harder to see. It appears that the market as a whole has been declining steadily, with all types of stocks and mutual funds showing losses. Diversification may not protect you from losses in a down market, but it may help to reduce the severity of your losses. So, pick a well-diversified portfolio and stick with it throughout the various market stages.
Eric Weisman is a Trinity senior.
This column is not intended to replace the advice of a professional financial adviser. This column is also not intended to solicit readers to buy or sell, nor is the author licensed to do so.
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