One of the surest ways for an investor to avoid catastrophe during a market downturn is to have a diversified portfolio, which is a lot easier than you’d think
Diversification is one of the most important facets of a successful portfolio, and we hold in such high regard here at MyWallSt, that it is one of our 6 Golden Rules. Diversification means accumulating a variety of stocks from different markets and sectors. This helps to reduce exposure to market volatility.
To put it simply: in the case of a market downturn, having investments in a number of different companies across different sectors is a lot safer than sticking to just one group of stocks. A lot of people lost everything during the Dot-Com Crash of the late nineties. Diversifying can help investors avoid a similar fate.
How many stocks do I need for a strong portfolio?
We believe that the minimum number of stocks a healthy portfolio should have is 12. It is important to understand though, that this doesn’t mean you should just go out and invest in the top 12 companies in the S&P 500 (NYSEARCA: VOO) and hope for the best. There’s a little more to it than that.
You should also spread your portfolio across at least 6 different sectors. This can range anywhere from Tech to hardware, or SaaS to restaurants. This is an important part of diversification because it allows you to spread your risk.
Take the COVID-19 pandemic for example: the airline and restaurant industry have taken a massive hit from this. However, the likes of tech stocks such as Zoom (NASDAQ: ZM) and Netflix (NASDAQ: NFLX) are booming, as are SaaS services such as Atlassian (NASDAQ: TEAM). If you were only invested in stocks within the restaurant industry, your portfolio would be looking pretty frightening right now.
Although it does not guarantee against loss, diversification is one of the most important components for reaching long-term financial goals while minimizing risk.
How do I know a company’s cap size?
Depending on your specific goals for your portfolio, you should invest in a healthy mix of small, medium, and large-cap stocks. If you are looking for a less risky, slow growth portfolio, then you’re best off investing in large-cap companies such as Apple (NASDAQ: AAPL), Amazon (NASDAQ: AMZN) and so on.
However, if you wish to see potentially explosive gains over a shorter amount of time, then small to medium-cap growth stocks might be more your style, such as Slack (NYSE: WORK), or Shopify (NASDAQ: SHOP). These stocks are usually younger, riskier, but growing fast and gobbling up market share.
However, it is not a guarantee that small-caps will grow, or that large-caps are always stable. The trick here is to get a healthy balance.
How do I balance growth stocks, slow growers, and stalwarts?
As noted above, the type of company you invest in will depend on what you are looking for from your investments. Simply hoping to build a nest-egg for retirement, or are you more ‘gimme all the money now?’ Well, if you’re the latter, I’m afraid you’re out of luck, because patience is the key to long-term wealth in investing.
Peter Lynch, one of the greatest investors of our time, categorised stocks in six ways, depending on what industry they were in and what you should expect as an investor in terms of returns:
- The Slow Grower: Usually large-cap, grow slowly in times of plenty, but also fall slowly during downturns.
- Stalwarts: Generally remain stable through the toughest market conditions because people always need what they offer. Think of toothpaste-maker Colgate (NYSE: CL). Whether boom or recession, people need to brush their teeth.
- Fast Growers: Smaller, younger companies that are having a big impact on the market with increasing revenue on a consistent basis.
- Cyclicals: Companies whose profits and sales rise and fall at regular intervals, such as automation and airline stocks.
- Turnarounds: Companies that are in trouble could potentially turn things around with some clever fixes. Chipotle (NYSE: CMG) is a great example.
- Asset Play: Companies whose assets may not be reflected in their bottom line, such as a retailer that’s in trouble due to a changing market, but actually has millions worth of real-estate.
For beginners it is always good to have a mix of slow growers, stalwarts, and fast growers. It is always a bit ‘safer’, for lack of a better word, to invest in the slow growers and stalwarts, which usually best-represent the overall market. And so far, since its inception, the market returned 10% annually (before inflation) over a ten-year period.
However, as you begin to get more confident in your investing life, perhaps you can venture into some riskier investments.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.