Diversification is supposed to protect your portfolio in up and down markets. However, for many investors diversification did not work last year. What do you do going forward?
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How Diversification is supposed to Work
Diversification is based upon reciprocity, the law of averages, and the faith that the stock market will keep going up over time. The assumption is that when the price of oil goes up, for example, industries that use a lot of energy will have higher overhead and make less money whereas the oil, coal, and natural gas industries will make more money. So, if you practice diversification over several sectors you will protect yourself, so the assumption goes.
So, why didn’t diversification work last year? Basically it is the faith part of the equation. When investors lost confidence in the system in the face of a bear market and recession they pulled their money and the receding tide lowered all ships. Yes, big oil still had a great year but that was because of profits through the first part.
So, What’s Next with Diversification?
For the time being it is probably best to invest on a stock-by-stock basis. Until more money reenters the market and a trust level builds again some of the old rules will likely not work.
Right now everyone is trying to outguess the system as signs of recovery from the recession emerge. We see the recovery market going up and we see profit taking. Strong companies with cash will survive and, if not already bid up, are good long-term investments. Diversification may work again in a couple of years but we will need to see more stable economic picture first.
Down the Line
It is likely that as the recession rights itself that in bull and bear markets a strategy of diversification will work to a degree. The “take home lesson” from this may be that in long term investing as well as short term investing one needs to pay attention to each of ones stocks. What was a well-run company with an excellent product line one year may become second rate after a takeover and poor management. A leveraged buyout may temporarily raise a stock price and leave the company weak and non-competitive. Buy and hold works if you keep paying attention to what you are holding. A periodic review is always in order, reading those quarterly reports and what experts are saying about the near and long term prospects of any given stock.
The recession will be gone in a year or maybe less. Now during the recovery is the time to be making wise long-term investments in stocks that are selling below their long-term market value. Reassembling a sound portfolio with an eye towards diversification is not a bad thing but for now the best stocks in the strongest sectors is probably the way to go. After the recovery, when the market is back to normal look at balancing your portfolio.