Diversification is not well understood. To many, simply buying shares of several different companies is adequate. However, if all of those companies are subject to the same market and economic forces, are you truly diversified?
For example, if you own shares in four of the major oil companies, all of them are going to rise and fall due to the same changes in the market, commodity price, OPEC decisions, and more.
The lack of diversification might be even more subtle. For example, owning shares of different companies not in the same industry may be equally non-diversified. Just because a portfolio consists of stock in companies of different market sectors, does not mean the portfolio is diversified.
True diversification takes many forms. If you limit the form of diversification to stocks, make sure the sectors involved are not subject to the same influences. Don't overlook cheaper and often forgotten stocks, either. Your profit potential can be enhanced with quick and easy ideas for these companies. Beyond direct ownership of stocks, you can diversify by:
1. Buying shares of ETFs or traditional mutual funds.
2. Diversifying by degrees of risk, for example combining selection of strong value investments with a smaller degree of speculation in more volatile stocks.
3. Combining stock ownership with option speculation.
4. Dividing a portfolio among stocks, bonds, commodities and real estate. (And by the way, you can invest in any or all of these without owning directly, if you seek a specialized ETF with ease of trading and built-in diversification within each ETF).
In summary, just be sure that the various baskets contain different kinds of eggs. Most traders and investors know better than to put all of their eggs in one basket, but if you are carrying all the baskets at the same time and you trip, don't all of the eggs break?
Another intriguing thought is, Do you need to diversify at all? If you can eliminate market risk by hedging stock positions with options, this is a question worth exploring.
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