NEW YORK (MainStreet)It is very important for young investors as well as a new investors to diversify their portfolios. The reason for diversification is to protect the you: in the event that one specific sector in the stock market fails, or is at a low, other investments in other sectors may bring you back. Profitable opportunities can be missed and disasters can arise if not done properly. But if done correctly, diversification can be a life saver.
In the stock market sectors range from basic materials and consumer goods to health care, industrial goods and technology. Data will be released 24/7 about these sectors and the stocks within them. Each sector has different news, either good or bad, that could sway your portfolio dramatically.
Let's say that you have not diversified your portfolio correctly, and you have only stocks within the Pharmaceutical sector. You eventually buy Pfizer Inc. (PFE), Johnson & Johnson (JNJ) and Novartis (NVS), which are very recognizable companies in medical and drug sector services. You have low liquidity within your portfolio and are depending on these specific stocks. Let's say the International Foundations of Medicine (IFOM) releases a statement that a generic ingredient, used in most drugs, has been labeled unsafe. All of the sudden, most of the stocks within this sector have dropped dramatically including the three that you have purchased. Not knowing how long the dip could be for, your funding could be trapped in those stocks for months until you have fully recovered.
As you hold these three stocks in the pharmaceutical sector, they are getting hit hard. Let's say, the next day, a chip is released into the market that is said to "revolutionize the technology world": as a result, all of the companies are using it to produce new products. Most companies within the technology sector are going up because of how the investors are "excited for the future." Now not only are you losing money in the pharmaceuticals, but now you have missed a huge opportunity in the technology sector.
Those two examples might be a little exaggerated, but occurances of that nature are completely plausible. This could absolutely happen to anyone in the market if they are not diversified correctly. The goal is for you not to spread your funding too thin, but rather to contain stock in more than one place at a time for security.
Let's take three stocks and move them to different sectors of the market. Now you contain Amazon.com (AMZN) in the services sector, Exxon Mobil Corporation (XOM) in the basic materials sector, and Wells Fargo & Co. (WFC) in the financial sector. Each stock has virtually nothing to do with the others. Let's say that the companies in the basic material sector are not having a good quarter due to scarce resources and minerals. When quarterly earnings reports are released, the investors will not happy. Unfortunately XOM spikes harshly downwards. Now that you have diversified your portfolio correctly, you still have AMZN and WFC holding their head above the water, and the fluctuation in your portfolio is not too dramatic. Now you still have two dependable stocks, which may be in positive territory. In the event that you need funding, it can be liquidated.
Diversifying your portfolio also implies to the markets, such as the Nasdaq, Dow Jones, S&P 500, and the international exchanges. As you know, the Dow Jones has reached an all-time high north of 15,000, and the S&P 500 at 1658.78 while the Nasdaq is stretching its 52 week high.
When picking stocks, either long-term or short-, make sure not to invest in only ONE stock or ONE sector of the market; that is only a recipe for disaster. It is very important for new and young investors to understand diversification at an early stage. Many do not understand how volatile the stock market really is.
--Written by Max Levin for MainStreet
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