As the saying goes, do not place all your eggs in one basket. This is perhaps one of the most important lessons when discussing investment management and retirement planning. (This post will solely cover diversifying stock positions, and we will be releasing a post targeted toward bonds and miscellaneous investments in the coming months.)

Before we dive into the various diversification options, let’s cover what this strategy means. Overall, diversification means purchasing various investments to create a risk-managed blend. By purchasing multiple assets, you spread the risk across numerous companies or numerous funds. The more investments you hold, the less chance you will incur, but this will be accompanied by less potential.

Owning 100 stocks is safer than owning one store, but you will experience less growth if that one stock takes off. This is because the owned companies will only be 1/100th of the size in a diversified portfolio. If you focus on only a few ideas, it is best to make sure you are confident in those choices because while there is more upside potential, the downside risk is just as significant. On top of simply purchasing more positions to diversify a portfolio, there are also other characteristics to consider.

We do feel the need to address the concern of over-diversification. Having your investments spread too thin will severely hinder the potential for substantial growth. It is essential to focus on the companies and areas that will outperform and decrease exposure to those expected to underperform. Warren Buffet once said, “Wide diversification is only required when investors do not understand what they are doing.”


stock diversification


Sector Diversification

Multiple different sectors are included in the overall stock market. These sectors include Technology, Healthcare, Financials, Energy, Utilities, Industrials, Consumer Staples, etc. Purchasing only one industry relies heavily on that specific industry. We believe that a blend of sectors is appropriate in any environment, but the correct combination depends on the state of the economy. Some enterprises perform better in an expanding economy, and some perform better in a contracting economy.

For example, Energy is based firmly on the price of oil and economic production. If there is a slowdown and the economy weakens, corporations will not be purchasing as much oil, travel will decrease, and this industry will suffer. On the other hand, Consumer Staples includes toilet paper and laundry detergent suppliers. These companies are always in demand since these are essential items for human life, but these companies will also not experience much growth if the economy is expanding. Staples are very cons, therefore, staples through various economic stages. Technology also performs well in a growing economy since companies spend more money on their technological research and design advancements. Utility companies perform well during slowdowns since individuals and businesses still need to pay their monthly bills. Financials perform well in an expanding environment because companies and individuals can afford more debt and banks earn the interest on the loans they issue. These are just a few examples, but every sector has a preferred economic environment in which it thrives compared to other industries.

Now that we know the basics of sector diversification, how do we apply this to a portfolio? It depends on the stage of the economy. Aggressive sectors normally perform better in growing economies, and conservative companies usually perform better during economic slowdowns. Aggressive sectors also typically see more swings in their stock price, and defensive sectors typically provide the benefits of dividends to shareholders. This is precisely why we utilize a rotating sector strategy with our in-house portfolios. Depending on your personal risk tolerance and time horizon, your preferred blend may vary from others’. Active management allows us to buy and sell our preferred sectors, while a long-term buy-and-hold strategy may potentially benefit the most from a blend of various sectors.

Factor Diversification

Market Capitalization refers to the size of the investable company. Typically, these are Small Cap, Mid Cap, and Large Cap companies. Smaller companies are usually considered more aggressive positions because they do not have the history nor size to withstand large financial strains. On the other hand, large companies have more assets, more revenues, and usually a longer track record as well. Therefore, large companies are considered safer investments. And, of course, medium-sized companies fall right between their small and large competitors.

The investment Objective refers to the company’s internal goals. These are very similar ideas to the market capitalizations listed above. Included in these objectives are Growth, Value, and Blend. Growth companies typically focus on increasing revenues, profit, and share prices. Value companies focus heavily on maintaining consistency in their business operations and preventing unfavorable fluctuations in their stock price. Value companies also often tend to provide dividends to shareholders. Blend companies try to balance both growth and value. As we mentioned, investment objectives often align with market capitalization. Small companies usually focus on development and large companies usually focus on providing stable value. Medium-sized companies often fall into the blend category.

So, now that we have discussed the different types of factor diversification, how do we apply this to an investment portfolio? Well, of course, it all depends on the individual investor and their personal goals and objectives. Those who are more aggressive and do not care about wild swings in their account balance could focus on small-growth-focused companies. Individuals who want to protect their account balance and invest in strong, household name companies could concentrate on large-value companies. Medium-blend-focused companies may be the best fit for those in the middle. With this being said, we do believe that a mixture is often the best move. Small-growth companies perform best when the economy is growing rapidly. Large-value companies are best when the economy experiences a slowdown. By holding both, you can potentially position yourself appropriately for whichever direction the economy moves.

If you have any questions about taxes, your investment portfolio, our 401(k) recommendation service, or anything else, please call our office at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or overall financial situation, please give us a call to discuss it.

If you found our article helpful, consider reading our other recent posts on Record InflationFiduciary vs. Financial Advisor, and Roth IRA Conversion.

We hope you learned something today. If you have any feedback or suggestions, we would love to hear them!

Best Regards,
Zachary A. Bachner, CFP®
Robert L. Wink
Kenneth R. Wink
James D. Wink
Summit Financial Consulting