Diversification - Your Free Lunch

Investment diversification has been called the "Free Lunch of Investing". Rightly so, Wall Street can serve up some nasty surprises with your money, but diversifying your portfolio against risk is entirely within your control.

Jim Cramer of the "Mad Money" television program on CNBC moderates a segment of his show titled, "Am I Diversified?" In it, his viewers call in and deliver their 5 largest stocks in their portfolio. Jim then decides yes or no if they are diversified or not. I like this, because it is helpful to all the viewers, no matter what your situation, and it works for both investors and traders alike.

To get started understanding diversification, the stock market can be broken down into sectors, represented as such:
CONSUMER DURABLES
CONSUMER STAPLES
ENERGY
FINANCIALS
HEALTHCARE
INDUSTRIALS
SERVICES
RETAIL
TECHNOLOGY
UTILITIES

These are fairly broad categories, as there are about 5,000 stocks traded on the three major stock exchanges. Next, place your stock into these 10 slots to determine your diversification. Go to finance.yahoo.com, enter your stock symbol, and then click profile to view your stock's sector. If you own 10 stocks, and more than 2 are in the same sector, you probably are not properly diversified.

There are those who disagree with this lesson, stating that they may choose not to invest in certain sectors based on their research. That is okay, but that increases your portfolio risk when you stray off target. For the average investor that doesn't manage money full time, my strategy is advisable as it lessens your risk of owning too much in any one sector or industry. It does not require you to cover all the sectors; just don't place too much in any one sector - say 15% maximum. Why? If that sector performs horribly (financial stocks, for example), it won't crater your portfolio. The same holds true for mutual funds held in your retirement accounts. Do they own the same sectors of stocks in more than one fund? What is the sector breakdown between your retirement account mutual funds and your other funds and stocks? If you own mutual funds in your retirement account, the quarterly reports would contain the sectors invested in; or call the fund company and ask them. Or, call me and I'll arrange a consultation to run the numbers for you.

In reviewing portfolios of stocks and mutual funds, I continue to see diversification violations big time. Hewitt Associates' recent research showed 21% of the respondent's 401K plan balances held company stock shares, and fewer than 1 in 5 make any transfers in their investment choices in a given year. What that shows me is that they are not "watching the pot" of money very closely.

While reviewing a 401(k) statement from a prospective client I advised in 2001, I noted that 75% of her portfolio was invested in her employers stock, which happened to be a major regional bank you'll see on the corners of Fort Lauderdale. We'll, maybe she made some changes the past few years, maybe not. The bank's stock declined 20 points over 8 years, or 30%, while the general market has been up since 2001. Lastly, a close family friend also owned a banking stock which represented 40% of their portfolio back in early 2006. Long story short, even though some shares were sold along the way, the result thus far has been more than a $1 million decline. These are tough lessons to learn from.
If you are not quite sure of your financial future, seek a professionals advice. I've been managing money and risk for folks since 1982. Be careful out there.