Everyone knows diversification is important when investing and trading stocks.
The quote “don’t keep all your eggs in one basket” always comes to mind.
However, most people think about diversification the wrong way, and what ends up happening is they ‘di-worse-ify‘ their portfolio instead.
In this blog post, we will discuss how most people get portfolio diversification wrong, and how you can avoid making the same mistake!
How Rookie Stock Investors and Traders Get Diversification Wrong
For the average person, stocks are one of the most important investments they will make in their lifetime.
Therefore, it is critical to understand how to properly diversify your portfolio across different stocks, in order to minimize risk and protect your investment.
The biggest mistake people make when it comes to diversification however, is thinking that they need to buy a set number of stocks across different industries in order to achieve diversification.
For example, an amateur investor might split up their account into 20 separate positions, and attempt to fill it up with:
- 5 stocks from the technology sector
- 5 from the health care sector
- 5 from the oil and mining sector
- 5 from the banking and finance sector
This is a terrible mistake for a couple of reasons.
First, not all sectors are equal – some years, some sectors will outperform others, so more opportunities would appear in one year over the other.
One year the best performing sector might be the tech sector. The next, it might be health care. And another year, it might be non-essential consumer goods and services.
So it makes no sense to give them all equal weighting at all times and limit themselves to an artificial quota just for the sake of ‘being diversified’.
Second, what they should be doing is basing their stock purchases on well-executed due diligence (a fancy way of saying research), while letting diversification take care of itself through something called position sizing (I’ll explain what that is in a second).
How Position Sizing Automatically Takes Care of Diversification
Position sizing is the process of determining how many shares of a stock you should buy, based on the overall size of your portfolio and your desired level of risk.
For example, if you have a $10,000 portfolio and you decide you want to take on what you consider to be a moderate amount of risk, you might decide to invest $200 in a stock. In this case, your position size is $200, or 2% of your portfolio.
By sticking to this, you will naturally be diversified across a number of stocks across different industries – BUT ONLY if you have a good system for identifying stock opportunties and researching stocks before deciding to take positions (i.e. buy stocks in the amount of your chosen position size) in them.
Here’s how it might work:
1) First, you will need to research the best quality stocks from a wide range of different industries. A good way you can do this is to follow my FREE 10-step checklist, which you can download here.
2) After that, you keep a close eye on the best stocks you have screened out for yourself until the opportunity comes up to purchase them. You can learn a bit more about market timing through our FREE Online Masterclass, which you can register for here.
3) And if you simply focus on sticking to your chosen position sizes for stocks, you will naturally be diversified because you will always be buying the right stocks at the right time. The reason for this is because as I mentioned before, the best performing stock sectors are always constantly shifting. For example:
- If you take multiple positions today in the top 1%, and end up with mostly stocks in the tech sector.
- The next quarter you might take more positions in the top 1% again, which this time is comprised mostly of stocks from the banking and finance sector.
- The quarter after that, the top 1% of stocks might be from the consumer goods sector – or it might be the banking and finance sector again (it doesn’t matter as long as it’s still the best opportunity).
So just by sticking constantly to the top 1% of stocks and taking positions when the opportunities arise, you will achieve what I call natural diversification in your portfolio.
If you follow these steps and let position sizing take care of diversification for you, you will be well on your way to achieving the level of diversification you need without over-complicating things or making rookie mistakes!
Best of luck, and stay safe.