4 Steps To Choose Stocks For Diversification

Why is it important to diversify your portfolio?

If you’ve ever heard the timeless advice, “Don’t put all your eggs in one basket”, the expression is incredibly applicable to trading.

Let’s imagine that a trader invested all their capital into a few tech stocks in 2022, such as Microsoft, Nvidia, and Meta. An increase in interest rates by the Federal Reserve in 2022 led many tech stocks to tumble, as they had been previously dependent on 0% interest rates. Our trader in this situation would now be at an overall loss, as his investments were too focused on one industry. This is why diversifying is crucial.

Diversifying has many other benefits:

• It helps to mitigate risk, as it reduces the impact that poor performance of individual assets has on the wider portfolio.

• It increases the odds of positive returns across your portfolio, leading to a more stable income.

• Diversification helps to manage the volatility of the market, by preventing the entire portfolio from being overly exposed to the performance of a single asset.

• It also allows your portfolio to more easily adapt to different market conditions, as some perform better in certain economic environments than others.

• Diversifying also helps to reduce stress, as a downturn in one sector might be offset by a surge in another, reducing emotional responses.

Because diversification has so many advantages, it’s important to implement it into your trading strategy by choosing stocks from across a range of sectors. Diversification can be achieved by also looking at the overall qualities of each stock and assessing its performance.

Let’s look at 4 steps you can take when choosing stocks for diversification.

1. Understand Your risk tolerance and investment goals

2. Analyze individual stocks thoroughly

3. Consider diversification by industry, size, and geography

4. Focus your selection on 20-30 stocks with strong fundamentals.

Consider your investment goals and risk tolerance

Take your trading goals into account and balance them against your own risk tolerance. If your investment goals are long-term and you want to see steady growth over a long period of time with little risk, you may be better served by selecting blue-chip growth stocks with little volatility, for example. If you are aiming for higher gains in a shorter amount of time, you will likely need to take on higher levels of risk. You can achieve this by choosing multiple stocks that display medium to high volatility. By day trading higher volatility stocks, across different industries, you can maximize your chances of seeing quicker returns, though the risk of incurring losses is also higher.

Do your research

As is always the case with trading, it is crucial to do your own research before each investment you make. When you are narrowing down your selection of stocks, consider the industry and market trends in which the company operates. Factors such as technological advancements, regulatory changes, and market demand can impact a company's performance. Evaluate the company's competitive position within its industry. A strong competitive advantage, such as proprietary technology or a dominant market share, can contribute to long-term success.

Consider diversification by industry, size, and geography

Diversifying your investment portfolio across industries, sizes, and geographies implements a strategic risk-management approach. By avoiding over-reliance on a single sector, company size, or geographic region, you mitigate the impact of adverse developments in any particular market. For example, if certain geopolitical events or government policies affect the entire US market, having a diversified portfolio that includes stocks in Japanese or UK companies would hedge against this. Similarly, if the tech market were to suffer a sudden downturn, having investments in other sectors could offset its poor performance.

Look for stocks with strong fundamentals

Assess the company’s fundamentals when looking at each stock, choosing those with a strong outlook. Understand the company's financial health by analyzing its financial statements, including balance sheets, income statements, and cash flow statements. Look for trends in revenue, earnings, and profit margins. Also assess the company's historical earnings and revenue growth, as consistent growth is a positive indicator of a company's ability to generate value for shareholders. Additionally, assess the quality and experience of the company's management team. An effective leadership team is crucial for making strategic decisions and navigating the company’s challenges.

The main focus of diversification is to pick stocks whose behavior will be as unique as possible in comparison to other investments in your portfolio, so that the price movements of your whole portfolio will not necessarily follow the same patterns as individual assets. You can also be interested in information about How Do I Start A Small Portfolio read the Traders Union article.

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How many stocks should you own?

As a stock trader, it’s crucial to have the optimal number of stocks in your portfolio. If you hold too many stocks (over-diversifying), the potential for large gains to significantly impact your bottom line is reduced. However, if you don’t diversify enough, then large negative movements can impact your overall returns too much.

Although there’s no one-size-fits-all answer to how many stocks you should own, a general rule of thumb is to have a portfolio of about 20-30 stocks. If you were over-diversified, with 50 stocks in your portfolio, and one stock saw a sudden 50% gain, your overall portfolio would only see a 1% increase.

Conversely, if you didn’t diversify enough and had 10 stocks for example, a 50% dip in one stock would translate to a huge 5% drop in your bottom line. Having around 25 stocks allows you to make strong enough gains from significant movements without taking on unnecessary risk. A 50% gain or loss on one stock would translate to a healthy and manageable movement of 2%.

Tips on choosing stocks for portfolio diversification

• Utilize diversification tools. Consider using index funds or exchange-traded funds (ETFs) that track broad market indexes, such as the S&P 500 or the MSCI World Index.

• Rebalance Your portfolio regularly. As market conditions change and individual stock prices fluctuate, rebalance your portfolio periodically to maintain your desired asset allocation and risk profile.

• Seek professional guidance. If you lack the time or expertise to conduct in-depth stock research, consider seeking guidance from a financial advisor who can assist in portfolio diversification and stock selection.