Understanding Stock Diversification
Investors seldom put all their eggs into one basket. Rather they prefer to invest in a variety of different financial instruments. We call this technique diversification, and it’s done to both maximize return while at the same time minimize their overall risk. Of course you could maximize your potential return by taking on greater risk, but since the risk is greater you stand a much higher chance to lose your big return. Diversification hedges your investments against the potential to lose it all.
Experts agree that a good stock portfolio will contain stocks that offer a balance between risk and safety. High growth, low-cap stock offer the greatest potential for profit, but they also offer the greatest potential for loss. Low-growth stocks are generally safe from large losses, but they seldom provide the opportunity to earn huge profits. Value and cyclical stocks can also be risky, but again offer the investor the chance to earn larger profits. Among the safest stocks to buy are preferred shares of stocks that pay consistent dividends.
The savvy investor will diversify their stock portfolio by including some of each of the various types of shares. For example if an investor has $100,000 to invest in stocks and they want a diversified portfolio they may choose to purchase stocks as follows.
$60,000 -> Dividend paying preferred stocks. This provides a consistent source of passive income, and are most likely in low-growth, non-cyclical companies.
$20,000 -> Value and Cyclical stocks. These will be actively traded shares that require more consistent care from the investor to mitigate risk and maximize return, but do not require attending on a daily basis. They are more risky than the dividend paying stocks, but less risky than the high-growth stocks.
$20,000 -> High-growth stocks. High growth stocks are the most risky and may require tending to on a near daily basis to keep risk at bay and maximize return.
The example give above is for educational purposes only and does not reflect actual investment advice, always check with a qualified investment professional first.