Employ a top-notch investment portfolio diversification strategy that employs a range of tactics

When it comes to developing an investment portfolio diversification strategy, don’t let sound bites and vague predictions warp your stock-trading decisions. Instead, minimize your portfolio risk by following our three-part Successful Investor approach: Invest mainly in well-established, dividend-paying companies; spread your money across most, if not all, of the five main economic sectors; and avoid stocks in the broker/media limelight.

By diversifying, investors help minimize the risk of portfolio imbalance. This has two main benefits. It keeps you from investing too heavily in any industry or sector that is headed into a period of big losses. In addition, by spreading your investments out more widely, you improve your chances of latching onto a market superstar—a stock that will wind up producing two or five or 10 times more profit than average. Over the course of any investing career, you need a few super stocks in your portfolio to offset the losses you’ll have from the inevitable duds.

Here are some tips on diversifying your stock portfolio:

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1. 1. Be sure to diversify by sector:
      • When it comes to a diversified stock portfolio, stocks in the Resources and Manufacturing & Industry sectors generally expose you to above-average share price volatility.
      • Stocks in the Utilities and Canadian Finance sectors entail below-average volatility.
      • Consumer stocks fall in the middle, between volatile Resources and Manufacturing companies, and the more-stable Canadian Finance and Utilities companies.
   2. Diversify geographically: One of the worst things you can do is invest so that your portfolio would suffer a great deal due to a localized downturn in any one city, state or province. Ideally, your portfolio should give you exposure to much of the North American economy, plus sufficient international exposure, if only through North American multinationals.
   3. Hold a reasonable portion of your portfolio in U.S. stocks: We continue to recommend that Canadian investors diversify part of their portfolio (around 25%, say) in well-established U.S. stocks. That’s because the U.S. market features major multinational opportunities that simply aren’t available anywhere else. As well, many U.S. firms are unique world leaders.
   4. Emphasize balance to help minimize too much exposure to one investment approach in your investment portfolio diversification strategy

Balance aggressive and conservative investments in your Successful Investor portfolio, in line with your investment objectives and risk tolerance. Above all, avoid the urge to become more aggressive as prices rise and more conservative as prices fall.

We believe you should develop a clear idea of how much risk you are willing to accept, through good times and bad. For example, some investors become more aggressive as the market rises and more conservative as the market falls. The problem here is that all market trends, up or down, eventually reach a turning point. If you take on more risk as the market rises, you’ll wind up owning your riskiest portfolio just when the market is near a peak. That’s when risky stocks can do their greatest harm to your net worth.

Furthermore, building a balanced Successful Investor portfolio should include a mix of growth and value stocks, big and small stocks, and so on.

1. 1. Use the bottom-up approach within your investment portfolio diversification strategy to get the best from today’s stock market

We think that most investors are far better off with “bottom-up investing” as opposed to “top-down investing.” Bottom-up is where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy a diversified, balanced selection of stocks that represent prosperous businesses with a strong hold on their markets.

Over periods of five years and beyond, top investment honours generally go to a member of the bottom-up investing crowd. That’s partly because bottom-uppers tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferrals and lower brokerage costs.

At the same time, we advise you to invest this way within the framework of our three-part Successful Investor portfolio strategy:

1. • Hold mostly high-quality, dividend-paying stocks.
   • Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
   • Downplay or stay out of stocks in the broker/media limelight.

Bonus tip: Can you diversify with bonds?

As for diversifying, it’s of less use with bonds than with stocks. When interest rates or inflation rise, all bonds suffer, though damage varies. If interest rates rise enough to spark an economic downturn, it can drive junk-bond issuers into bankruptcy.

During this scenario some investors will stick with low-yielding government bonds and see what happens. We prefer to hold stocks yielding 1.5% to 3%.

After all, high-quality stocks offer yield plus growth. They will go on to higher prices and higher dividends, regardless of inflation or interest rates.

Some investors “diversify” with a sector rotation approach, which can be controversial. What have your experiences been with this approach?