When it comes to investing, there is no question that diversification goes a long way to help you manage risk. It can be from several angles, but a simple and effective way is to start with sector diversification. With sector diversification, you reduce your risk by investing in stocks and securities in different industry sectors. You can further diversify by investing in multiple companies within each sector.
What is Diversification?
A diversification strategy involves investing across different asset classes. In addition to stocks and bonds, other asset classes like real estate can also be included in these asset classes. If you invest all your money in large-cap value stocks or only government bonds, you shouldn’t put all your wealth into one investment.
Why Diversification Matters
Think about this way, if you own one stock and that stock drops to zero, you lose 100 percent of your investment. On the other hand, if you own 10 stocks and one goes to zero, you only lose 10 percent.
The same reasoning applies to diversifying by sectors. If you only own one sector, and a market-changing event causes all stocks within that sector go down 50 percent, you will lose 50 percent of your investment. If, however, you are diversified in five sectors, and one sector takes a 50 percent hit, your entire investment portfolio will only go down 10 percent. In other words, diversification provides a buffer against loss.
Using ETFs to Diversify
What do you if you don’t have a big enough portfolio to invest in multiple stocks or sectors? In this situation, investing in Exchange Traded Funds (ETFs) may be a good choice. An ETF is a basket of securities that trades like a stock. ETFs provide a low-cost way to add diversification to your portfolio. By purchasing ETFs in multiple sectors, you can create a well-diversified portfolio.
The TrackYourDividends model portfolio aims to cover at least five sectors with no individual holdings over five percent of the entire portfolio. Below, you will see a sample diversified portfolio created with our diversification tool.
As you can see, ETFs account for a large amount of the portfolio (~48%). Next is financial services, (~18%), and so on. Our stock allocation diversification is slightly overweight in some places like JNJ and T but still outlines the diversification principle well.
The charts provided above are generated by our dividend tracking software.
The goal of TrackYourDividends is to help you make the best decisions possible about how you invest your dividend portfolio, including how you approach diversification.