Investing in stocks is risky. The adage, the "higher the risk, the higher the reward" rings true. One good stock pick might reap enough reward for you to retire. But if you pour all your money into the wrong stock, you could end up losing a bundle. Because of the inherent risk involved with investing in a single stock, most professional portfolio managers urge investors to diversify their stock portfolios to reduce their risk from exposure to any one company.
Risk of Single-Stock Investing
Investing in a single stock can be a good way to ride the success of a well-managed company. On the flip side, you also risk losing all of your money if the company is not as well-managed as you hoped. Holding onto one stock means you expose yourself to a number of factors that could send the stock on a downward spiral, including a weak economy, an industry slump, a sudden change in management or a disappointing financial performance. When things go bad, your sole stock pick might lose its value quickly, which means your investment loses its value quickly.
Benefits of Diversification
Diversification is all about reducing risk. Rather than holding onto one stock and hoping for its steady appreciation, professional investors diversify their portfolios to minimize the exposure to any one stock. If one stock in the portfolio declines in value, another stock picks up the slack. Opinions vary about the right number of stocks to hold in your portfolio. The idea is that each stock is unique in its volatility. But a group of stocks, if selected properly, are less vulnerable to extreme highs and lows.
Professional investors categorize stocks into cyclical, countercyclical, growth and income stocks. Cyclical stocks are those that tend to move up and down with the economy. Examples include airline, automobile and housing stocks. Countercyclical stocks are those that move in the opposite direction of the economy. These are companies that offer goods and services that consumers and business can't live without, such as drug makers and utilities. Growth stocks are those that tend to rise in value quickly, such as technology companies. Income stocks provide steady but slower growth and are more likely to pay dividends. A lot of big, diversified corporations fall into this group.
Adding Stocks to Your Portfolio
Picking stocks is part art and part science. Ideally, you would add stocks that provide a counterbalance to the stock you already own. Knowing whether your investment is in a cyclical, countercyclical, growth or income stock works in your favor. If you own a potentially high-growth but volatile technology stock, for example, you might want to mix in some slower-growth but steadier utility stock to reduce your risk and exposure.
Mutual funds are baskets of stocks that you can invest in to provide more diversification to your investments. A professional money manager is responsible for managing a mutual fund. She makes decisions on which stocks to include or exclude from the portfolio. One of the largest rating services, Morningstar, provides information about the performance of mutual funds. Rather than simply holding onto one stock, you can invest in a mutual fund that invests in stocks according to the stated investment objective of the fund. For example, an energy fund is one that only invests in energy stocks. Investment professionals can assist you and customize a stock portfolio that meets your investment needs.