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Introduction | Tips For Getting Diversified | Appropriate Diversification | Maximum Portfolio | Investments That Reduce Risk | Assest Class Mixes

Diversify

Maximizing the Performance of Your Total Portfolio

Diversification does more than just reduce risk. Over time, an intelligently diversified portfolio will almost always outperform a single holding. Indeed, even a not-so-intelligently diversified portfolio will probably do the same.

In fact, a case study has shown that even five randomly selected stocks would add value to an account. If they are chosen at random, they will probably be in different industries, grow at different rates, and respond differently to market forces. Long-term, an account containing these five stocks would have a higher average value than one containing only one of the stocks.

While nobody would advocate such a coin-toss approach to investing, there is a good case to be made for the passive strategy of investing. We looked at this in the Investment Vehicles chapter, under index funds. A passive strategy means that you buy a group of stocks that is diversified and hold on to them. Your portfolio doesn't need to be "managed" -- that is, with stocks and shares constantly being bought and sold. One passive investment method is to choose a selection of stocks that are representative of the overall economy, so that, for example, the percentage of General Motors stock you buy (your "weighting") would reflect GM's size compared with other companies in the U.S. economy's corporate sector.

This is the principle behind the indexes and averages that many mutual funds are linked to. The Dow Jones Industrial Average is based on thirty Blue Chip stocks traded on the New York Stock Exchange. The Standard & Poor's 500 Index tracks the 500 largest corporations in the country. An army of mutual funds, called Index Funds, attempts to track the S&P Index's performance. Other popular indices include the Wilshire 5000, the various Russell indexes and the Value Line Composite Average. You can invest in funds that mirror any of these indices, depending on your preferences.

You may still be wondering why the best strategy isn't just to put all of your money into a winning stock and watch it grow.

To begin with, it is impossible to know what will be a winning stock in a few years. What's more, it does not make financial sense to tie your retirement account to the performance of an investment that ends up doing well in the long run, but fluctuates a lot in the meantime. Minimizing the downside risk through diversification doesn't just protect the integrity of your investment; it actually enhances the total performance of your portfolio. To understand how, consider what we'll call the "up-and-down rule." Simply put, this rule says that a gain and loss of the same size are not really equal.

Let's say you invest $100 in an individual stock. In the first year, it gains 40%. In the second year, it loses 40%. See the chart below to find out what your $100 investment is worth after two years.

  Starting Value Performance End-of-Year Value
Year 1 $100 +40% $140
Year 2 $140 -40% $84
 
Total Portfolio $84

Are you surprised to find your investment has lost $16? Now let's see what happens if you diversify your portfolio by adding another stock, and invest $50 in each (instead of putting the entire $100 in one stock).

  Starting Value Performance End-of-Year Value
 
Stock A
Year 1 $50 +40% $70
Year 2 $70 -40% $42
 
Stock B
Year 1 $50 +10% $55
Year 2 $55 -10% $49.50
 
Total Portfolio $91.50

Because your diversified your investments among two stocks, your portfolio is worth $91.50 at the end of the two years. While you've still lost money, you have $7.50 more than you would have had by investing in just one stock.

So remember: any amount of short-term loss you can shave off is money you can reinvest toward the long-term buildup of your savings.


The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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