Diversification in the Real World

02/08/2010 10:42 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, tells investors that diversification is a critical tool in investing, and he discusses how to achieve it.

We constantly emphasize the importance of quality and value. At this [point], I have to add a third leg to the investment stool: diversification.

If you do everything right, have well-defined goals and objectives, choose asset classes that are appropriate for your time horizon and risk tolerance, select only the highest-quality stocks that represent historically good value, but fail to diversify across a broad number of industries and/or sectors, it can totally negate all of your preparation and hard work.

Throughout the history of the stock market, there are cycles where various industries and sectors have suffered major declines. Although there is often fair warning that trouble may be looming on the horizon for an industry or group of industries, there are an equal number of instances in which trouble has appeared out of the blue.

Although limiting investment considerations to high-quality blue chips that represent historically good values can often reduce any down side, there are instances, such as the complete meltdown of the financial sector, which no system of value identification could anticipate or predict. As such, it is important to limit your exposure to any one industry or sector.

In a perfect world, a portfolio of 25 stocks diversified across 25 separate industries or sectors would limit the overall portfolio exposure to only 4% in any one industry or sector. Under this scenario, an investor could suffer a total loss in any one position and emerge relatively unscathed.

Of course, we don’t live in a perfect world, and it isn’t always possible to diversify across that many industries or sectors, because they may not all offer simultaneous good historic values.

Let’s say the utilities sector offers historically good value and six or seven are currently undervalued. As utility stocks tend to have higher yields, an investor might be tempted to snap up all six or seven.

What would be more prudent, though, is to choose perhaps one gas utility and one electric utility that are based in different geographic regions. [That would offer exposure] to the sector but [diversification] by type of utility and by region.

Of course, there won’t always be such a clear-cut distinction. Among individual investors and in the professional community, there are some age-old battle lines drawn when it comes to certain industries: Procter & Gamble (NYSE: PG) versus Colgate-Palmolive (NYSE: CL); Coca-Cola (NYSE: KO) or PepsiCo (NYSE: PEP); Wal-Mart Stores (NYSE: WMT) or Target (NYSE: TGT), and so forth.

In these situations the investor must return to individual analyses and compare the fundamentals and strengths: Are they both [undervalued]; does one offer a more attractive price or dividend yield; does one have a lower payout ratio or debt level, and so forth.

In any event, the fundamental concept behind diversification is to spread overall portfolio risk as far as is reasonably possible so that the unexpected will not cause irreparable harm to the value of the portfolio.

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