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Diversify for portfolio balance

Aim for balance when you diversify your portfolio. Decide how much you should invest in each stock or industry group so that it will have meaningful representation.

Most investors learn the value of portfolio diversification quickly: When you diversify, you reduce your risk by spreading it over a broad range of industry groups. But to make this diversification meaningful, you must strike a balance in your holdings, so you avoid having too little or too much exposure in any one stock or industry group.

If you invest $1,000 each in a bank stock, a utility, a consumer stock, and a manufacturing stock, and $50,000 in an oil stock, you’ll diversify your holdings over those five groups. But the obvious imbalance renders that diversification meaningless: The success of your portfolio will depend mainly on how that lone oil stock performs.

How to strike a balance

Before you can decide on the right balance for your portfolio, you must first assess your investment objectives and how you want to achieve them. Then, choose investments in amounts that suit your objectives.

First consider how much of your money you would like to keep in cash for emergencies, fixed income for future cash needs within the next five to 10 years, and finally, equity.

Younger, employed investors with secure jobs should always hold an emergency fund, but may need few to no fixed-income securities. Older investors are more likely to need cash from their investments over the next 10 years. Therefore, more of their portfolio should be kept in fixed-income securities commensurate with those cash needs.

Choosing your stocks

To achieve the proper balance in your common stock portfolio, first decide if you want to emphasize growth, dividend income, or some combination of both.

Frequent traders will try to balance their portfolio according to their views on the immediate outlook of individual industries and stocks. Successful traders realize that there is considerable room for error in such an investment strategy.

So it’s all the more important that they spread our their investments. Typically, they might keep 15 to 25 per cent of their funds in any given stock or sector, saving the maximum 25 per cent, of course, for industries or stocks with the most promising immediate prospects.

Long-term investors, however, avoid trying to guess the immediate prospects of a particular industry. Instead, they allocate funds to each industry on the basis of how the industry’s characteristics suit their objectives.

Financial stocks and utilities, for instance, are apt to be interest-rate sensitive, have dependable dividends, and offer above-average yields. Manufacturing stocks and resource (oil, gas, mining and forestry) stocks, by contrast, are cyclical, and subject to dividend cuts and omission in recessions. But they’re often best for keeping up with inflation over the long run. Consumer goods stocks are usually non-cyclical, and non-interest sensitive.

Investors who emphasize dividend income above growth might balance their portfolio as follows: banking and finance, 25 per cent; utilities 25 per cent; consumer products, 20 per cent; manufacturing, 15 per cent; and resources, 15 per cent.

If you want to concentrate on growth in your portfolio, you should place more of an emphasis on resource stocks and manufacturing stocks. You could invest equally over the five sectors. Or you could put less of an emphasis on financial stocks and utilities, and more on growth opportunities in the manufacturing, consumer and resource spaces. For instance, you could put 15 per cent in financial stocks and utilities each, with the rest of the portfolio spread out across the remaining sectors.

Remember, these guidelines are just that—guidelines. As such, don’t treat them as rigid weightings, but as general suggestions to help you achieve your portfolio objectives.

This is an edited version of an article that was originally published for subscribers in the October 1, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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