The idea behind diversification is that it does not make sense to place all of your capital in one place. The risk is too great. So you spread risks by selecting different stocks or other products, so that no single economic, cyclical, or market event or news will disrupt your entire portfolio.
The methods of diversification are many. The best known among these is spreading risk by selecting different stocks. As a basic form of diversification, this move makes sense. Owning three stocks with equal dollar values in each, rather than placing all of your cash into a single stock, means that a decline in value of any one only affects one-third of the total.
This may not be enough diversification, however.
If all three stocks are in the same industry, a change in the economy affecting that industry is also likely to affect all three stocks. Industries tend to share the same business cycles and to react to economic news (unemployment, interest rates, currency values) in a similar manner.
Owning several stocks subject to the same kinds of market risks is not diversification; it is simply living with the same risks in different stocks.
Even different industries may react to the same economic news in the same manner. So simply holding several different stocks might still expose you to market risk. For example, if you hold stock in three companies, all of which do the majority of their business overseas, how will currency exchange trends affect value? If all of your companies rely on borrowing money to fund operations, how will rising interest rates impact stock prices?
To truly diversify among different companies, your holdings should be among companies that do not share the same vulnerability, especially to factors likely to hit the stock price in a negative way. For example, if you buy shares in companies in different industries but all are technology stocks, any factors hurting stock prices are likely to lead to declines in the value of your entire portfolio.
Another consideration in diversifying your portfolio is the level of market capitalization (market cap). This is a popular comparative measurement, representing the value of a corporation’s net worth (assets minus liabilities). Net worth primarily consists of the value of capital stock and retained earnings. Market capitalization is the sum of all outstanding common shares, multiplied by the current market price per share. So when stock prices rise, so does market cap; and when the market price falls, so does market cap. The distinctions are made among companies not so much due to daily price fluctuations but in broader terms.
The three primary categories in terms of market cap are large-cap ($10 billion or more of equity value), mid-cap (between $2 and $10 billion), and small-cap (less than $2 billion). Additional distinctions are made by some to include mega-cap, or companies whose net worth is greater than $200 billion; and micro-cap, including companies with equity value between $50 million and $300 million. These distinctions are important because they provide an important method for diversifying beyond simply buying different stocks. The big-cap companies are often the strongest in terms of market domination. These companies also tend to fit the definition of blue-chip companies, those paying dividends even in soft markets, with stable and growing earnings and little or no long-term liabilities. In selecting large-cap stocks, you opt for safety, but at times this may also mean lower-than-average volatility. Such companies at times, but not always, may move more slowly than the average company in the market. On the other end of the spectrum, small-cap stocks tend to be much more speculative because they are young and do not have a track record. However, those that succeed may do so with dramatic price appreciation. It’s important to remember that every large-cap stock started out as a small-cap stock. Market capitalization as a factor in diversifying is easily overlooked but can be one of the most important ways to spread risk. It’s similar to buying real estate. Where do you buy? How much are houses worth? Is the neighborhood on the rise or on the decline? Are high-priced homes appreciating faster or slower than average-priced or low-priced homes? Anyone who tracks the real estate market understands quite well how the price range of homes defines market trends. The same is true for stocks.
Large, well-capitalized companies tend to be safer. They may also tend not to offer as much profit potential. Picking the right long-term investments is a balancing act.
A method of diversification may be to spread capital among the three major classifications (large-cap, mid-cap, and small-cap) to expose yourself to potential price appreciation while also having a portion of the portfolio in safer companies with a longer track record. The market is huge, and you will have no problem finding companies in any of the classifications. The total value of all publicly traded companies is about $40 to $50 trillion (Reuters, March 21, 2007; and Federation of Exchanges, www.world-exchanges.org).
How much is a trillion? This amount is impossible to imagine. But some perspective helps. A stack of $100 bills adding up to $1 million is about five feet high. A stack equal to $1 billion is one mile. And a stack equal to $1 trillion is 10 miles high.
Diversifying by market cap is one of many ways to spread risk. An alternative to market cap is enterprise value (EV), which is a measurement of the entire business, including both equity and debt capitalization. Market cap is based on valuation of common stock alone; EV adds preferred stock as well as all long-term debt. You can also diversify in terms of liquidation risk, meaning buying some preferred shares to create an ultra-safe position for a part of your portfolio. You may also diversify by buying some domestic and some foreign stocks. Today, with the global online availability of trading, it is easier than ever to invest around the world. Many specialized funds also specialize by country or region. You can also diversify by investing in U.S. companies with a large share of income derived from overseas. Well-known examples include Johnson & Johnson (JNJ), Coca-Cola (KO), and McDonald’s (MCD), among many others.