Every time an investment adviser meets with a client for the first time, a topic that is sure to come up is "diversification." Generally, from an investment adviser's point of view diversification means investing in various different categories or segments of the market so that a severe downdraft in any one segment won't destroy a portfolio. For example, Jim Cramer has a segment on his "Mad Money" TV show called, "Are You Diversified?" He looks at viewers portfolios and determines if they are invested in at least 5 different market segments to announce if they are diversified or not. Typical categories for diversification would include but are not limited to: financials, energy, technology, health care, pharmaceuticals, telecom, basic materials, conglomerates, etc.
Diversification is important even when investing in mutual funds which by their very nature are made up of many stocks and at first blush might appear to automatically create diversification. However, mutual funds are generally very focused as large cap, small cap, growth, income, international, etc. So it is generally recommended not to have all your money in one specific type of fund. I personally believe that it is important to diversify even more than most. With my focus primarily on income, I believe that it is valuable to have multiple and very diverse streams of income as well as certain portions of a portfolio that are designed to grow, and to stem the tide of inflation. I would include investments in rental properties either by owning actual rentals, or through Real Estate Investment Trusts (REITs). I also believe in owning part of the infrastructure that produces, transports and stores oil and natural gas. This segment not only includes the big oil companies but also encompasses various Master Limited Partnerships (MLPs) involved in oil/NG exploration, pipelines and storage facilities. Like REITs, these entities offer high yields but unlike REITs they are tax advantaged and generally most taxation is deferred until they are sold. Further, I suggest diversification into Business Development Companies (BDCs), which were created by the Federal Government to enable smaller investors to have an opportunity to play a part in the growth and development of blossoming young companies. Prior to the creation of BDCs "Angel" investing in developing companies was limited to the large Venture Capitalist firms and high net worth individuals. Like REITs, BDCs pay no corporate taxes and therefore generally pay higher than average dividends, but again similar to REITS, their dividends are not "qualified" and the shareholder pays taxes on dividends at their regular tax rate.
One area that is often overlooked or accepted without thought is in a 401K or a 403B where your company or your institution is investing and managing your money for you. Often that money is invested 100% in the stock of the company. This puts the individual at extreme risk because he/she is also relying on that same company for a salary. Hence, if that company should for some reason go under, then the employee would not only lose their source of income, but a significant portion of their retirement income as well. If you are in one of these plans, be sure that the administrator knows your desires for diversification and acts accordingly.
While diversification is a very valuable tool, there is such a thing as over diversification which creates such a broad portfolio that it is impossible to manage. Everyone is different, but generally a portfolio of 15 to 20 equities is sufficient to diversify and still be manageable. Every investor has their own criteria for investing and tolerance for risk, so an individual's portfolio will reflect those characteristics.
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