Simulator How-To Guide: Diversified Portfolio

Probably the worst mistake a new investor can make is to not properly diversify their portfolio. Simply put, it is foolish to invest all your money in one investment. It may be tempting to invest your life savings in a "hot stock tip", but one of these hot tips may burn up your entire net worth. In short, diversify.

Since we are buying stocks throughout the course of this How-To Guide, let's focus on building a diversified equity portfolio. To do this, we need to understand a little bit about the nature of diversification, which is actually more common sense than you might expect. For example, consider the fast-food chain McDonald's Corporation (NYSE: MCD). They've been very successful in the past, but if a new healthy diet fad hit North America, their profits would likely take a nosedive. In fact, similar companies such as Wendy's Arby's Group. (NYSE: WEN) and Yum! Brands Inc (NYSE: YUM) would surely suffer comparable losses. If you had chosen to "diversify" your portfolio by investing in a bunch of different fast-food companies, you'd probably lose just as much money as someone who dumped their life savings into McDonald's stock.

Diversification is not simply spreading your money around into different companies; you have to diversify your investment funds into different types of companies. For example, if you currently own shares in Wal-Mart and wanted to make another investment, you'd be better diversified by investing in oil giant Exxon Mobil (NYSE: XOM) than Wal-Mart rival Target Corp (NYSE: TGT).

Of course, when we're making real-life diversification decisions, investors use a more scientific approach. The widely used GICS (global industry classification standard) system divides the economy into 10 general sectors, which we'll use as a model to diversify our portfolio. The 10 sectors are listed below; with an example of a stock that fits in that sector.
 

Suppose you already own WMT,TLAB and PIR we don't want to purchase any more companies from the Consumer Discretionary or Telecom sectors. However, we do need to purchase at least 8 more stocks, around one from the remaining 8 sectors. Feel free to use a stock screener to get a list of stocks within a given sector.

For example, you could run a stock screen for each financial sector to produce a list of stocks currently trading under that sector, and pick one or two companies from each sector that interest you and meet your analysis criteria.

This brief lesson is only the tip of the stock analysis iceberg (read our Stock-Picking Strategies tutorial for more in-depth coverage), so we can't possibly explain everything you might want to look at when comparing stocks. For example, you may want to look at the P/E ratios of all the energy stocks that you found. Which one has the lowest P/E ratio? Do you think its low P/E ratio is an indication it may be undervalued? If so, that could be one of the factors compelling you to choose that stock. Feel free to dig around the numbers and compare these stocks to each other, but don't spend too much time doing so; more advanced analysis techniques can be learned by reading through our website's many resources. A select few would be:

Fundamental Analysis Tutorial
Technical Analysis Tutorial
Advanced Financial Statement Analysis Tutorial
Ratio Analysis Tutorial
Investopedia's Industry Handbook

Feel free to read through these and other resources that we offer as regular reading goes a long way in improving your investment knowledge.