Diversifying Your Stock Portfolio: 4 Tips
I recently spoke with my mentee and the subject of investing came up. She explained not to have much knowledge in investing and just started investing in ETFs, because that was the safe thing to do while still being able to profit from the stock markets. As you know by now, I find this an interesting field. We talked about different financial securities, dividend, and diversifying your portfolio.
There are some fundamental concepts that I want you to be aware of and try to understand how this will influence your investments.
1. Stocks or ETFs
There are many securities to choose from, and stocks and ETFs are my favourites. Stocks are fractions of ownership in a company and the price depends on its value determined by investors. Investors buy stocks in a company with the expectation of its value going up over time. When you have one stock worth 100 euros and the value of this stock goes up by 3 dollars, you have a profit of 3 dollars if you sell this stock.
Other investors buy stocks for their dividends. If you own a stock worth 100 euros that provides an annual dividend of 3%, then you will receive money worth 3 euros after one year.
An ETF can be seen as a basket of different stocks. Some stocks in that basket may go up in value while others may go down. For example, if the value of stock A in the ETF goes up by 5 dollars and the value of stock B goes down by 2 dollars, the value of your ETF is up by 3 dollars. In this case, your virtual profit is lower compared to individual stock A, however, you are protected from individual stock B that goes down in value. A good note here is that some ETFs also provide a dividend, which you can find in their prospectus.
All stocks and ETFs go up and down in value but only certain securities provide a dividend. The dividend rate depends on the performance of the company. In which stocks you want to invest, depends on your expectation of the upward potential of a stock price vs its downward potential. This will require research and costs time. Otherwise, the ETF is a great alternative to spend less time on researching and hedge yourself from underperforming individual stocks.
2. Dividend investing vs Growth investing
Investors use different means for a common goal: letting money work for you. You can invest in the stock of a company with the prospect of it going up in value or because you want to support the mission of a business, and it can be for both reasons.
Investing in large-cap companies such as Coca Cola and AT&T is relatively safer and often comes with a nice dividend. This can let your money breed more money. However, as these companies are more stable, the upward potential of their stock price is probably smaller in percentage terms compared to small-cap companies like Palantir. These are companies that are promising but have yet to prove themselves in profit-making ability. Investing in small-cap companies is financially riskier, but the reward is potentially higher.
Figure out where your preference goes out to, what your risk appetite is, and in which companies you want to invest, ranging from large, established companies to smaller, but promising companies. In the search for investment opportunities, always assess the future potential of a company. Do you see it (still) thriving in the future? Here are some metrics for choosing the winning company.
While busy investing, you may lose oversight of the different sectors that your companies are active in. People often have a favourite sector and tend to invest a large portion, if not their total investment in that particular sector, for example, the technology sector. While that may have been a good move since the start of the pandemic in 2020, a sector that is booming now on the stock market may be prone to change in time.
The oil industry made a good run since the 1920s but its end is inevitable. Technology companies had a hard time during the internet bubble in 2000 and unless your company survived and you had the patience to diamond hand your stocks for 20 years, it is sensible to diversify your investments. Not everyone does this, and it can come with a high price. That is the trigger for a downward spiral for some companies, like Archegos Capital who is heading for bankruptcy.
Having too many stocks in one country or different companies that are only active in a single country could also result in problematic circumstances. Think of a situation where you have had all your investments in real estate companies that only invested in real estate in the United States during the housing bubble of 2008. That would not have been a pretty picture.
While some countries are known for being safe places for investments, there are risks to investing in any country. Be it due to geopolitical conflicts or monetary policy. For instance, if the inflation in the United States keeps going up, it would be nice to have investments in companies that are active in other investor-friendly countries.
And that is why creating a diversified portfolio is so important. You work hard for your money and making investments that are well-considered will make your money work for you. This is the formula for protecting yourself against volatility, underperforming stocks, sector rotation, geopolitical conflicts, or a bubble in the sector you’ve heavily invested in. Simply take into account the financial securities, large and small-cap companies, sectors, and countries to help you diversify your investments.