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Using Portfolio Diversification To Create An Investment Strategy That Works

While there are a glut of new investment strategies introduced every few years, there are still a few pillars that are the foundation of every successful, workable investment strategy. This article will take a look at these pillars and outline a few personal modifications you can make on an investment strategy depending on your time outlook and your risk tolerance.

Every successful investment strategy utilizes the power of diversification. Whether you are interested in doing fundamental analysis and selecting individual stocks or you want to cast a wider net and buy into some indexed exchange traded funds (ETFs), diversification needs to be the fundamental basis of your strategy. There are a few types of diversification you need to pay attention to.

Most important is sector diversification. Let's assume that you have some shares of an ETF that focuses on medium growth, mid-cap (cap stands for capitalization, which is a measure of the overall size in financial terms of a company. A mid-cap firm is medium sized in terms of the stock market) energy stocks. With this in mind, you want to move your assets towards sectors other than energy. The rationale for this move is fairly simple: by diversifying by sector, you avoid the risk of one-time shocks that may affect an entire industry. If there's an oil supply shock, there can be very significant consequences for all of the energy firms in your portfolio. If your portfolio is diversified by sector, then one-time industry specific shocks can't hurt your returns to a very large degree and you've reduced a large portion of unquantifiable risk.

You also need to diversify by asset type. This type of diversification depends in large part on your investment goals. For example, a young professional who can afford to take on a great deal of risk may wish to tailor his investment strategy to buying high-growth stocks. On the other hand, a retiree who needs some degree of regular income needs to tailor his investment strategy to buying fixed income instruments like bonds and certain types of income-oriented ETFs. Regardless of your overall strategy, asset diversification is still important. Nobody should have all of his assets in any certain type of investment. The industry standard for the average investor is typically something like 70% stocks, 20% bonds, and the other 10% in real estate and money market instruments. The rationale here is simple as well. If there is an unexpected shock to the stock market, it is unlikely to affect your entire portfolio if you are properly diversified.

Diversification by region is important. It's recommended that you spread your assets, at least to some degree, between geographical regions. If you are heavily invested in a particular country's stocks, then events specific to that country will have an abnormally large effect on your portfolio. Since it's a bit tougher to gather financial information on firms outside of your home country, it's less important to diversify by region because your returns for out-of-country stocks are naturally going to be lower. Your best bet in this case is to buy a region-specific, wide-index ETF.

Remember that when you buy into exchange traded funds that you are getting some degree of natural diversification simply because a fund selects a large number of stocks and other types of investment instruments to hold.

Article Source: http://www.articlesnatch.com

About the Author:
This guide was designed to help you craft a successful investment strategy while being able to make selections from the wide number of ETFs out there. This way, you double up on your total diversification. Not only do you get the safety of holding a large number of individual firms, but you're also spread between sectors, asset classes, and geographical regions.

Tags: etfs

, exchange traded funds

, investment strategy

, diversific

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