How Retail Traders Can Diversify Their Portfolios

Do you believe you can predict the market with 100 percent accuracy? Are you willing to risk all of your hard earned money every time you are wrong? Unless you are psychic, or have a license to print money, you probably answered ‘no' to both questions. However, when traders do not wisely spread their money around, they are telling the world that they are invincible and have money to waste. If you trade like you have money to blow, you will definitely have trading accounts to blow as well. For the rest of us, diversification is the way to make the correct statement with your money.

Diversification

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. This technique contends that a broad portfolio will, on average, yield higher returns and pose a lower risk than any single investment found within the portfolio.

To many retail traders, diversification seems unnecessary. It is term often discussed by money moguls like Warren Buffet, George Soros and the latest hot-shot Portfolio Managers on Bloomberg. In less prominent circles however, diversification is often an afterthought, or something traders promise to do once they have more money. Although it is understandable why so many new traders postpone diversification if they have less than $5,000 to trade with, diversification is essential for staying in the game long enough to make any real profit.

It's just a game

Imagine a poker game where the veterans at the table have $100,000 worth of chips and a novice pulls up a chair with only $3,000. The novice's mindset determines how he plays his hand. If he views his total winnings compared to the rest of the table, he is more likely to bet aggressively. Betting this way, his winnings might multiply quickly, but at a time when he is the least experienced at the table, he is the only one who cannot afford to make a single mistake thanks to his reckless strategy. One mistake or unlucky break and the novice is doomed.

If the novice accepts that everyone has played with only $3,000 to their name at one time or another, he will play the game intelligently and steadily compound his winnings. Granted, he will still make mistakes, but thanks to proper betting tactics, he will also have the ability to learn from those mistakes without going bankrupt. Trading is the same way. In order to make the money you want to make, you have to trade in ways that reduce risk and don't leave your bottom line to chance.

Ways to Diversify

When it comes to diversification, there are billions of ways to structure your portfolio. Rule #1 is to never put all of your money into one stock. It is the quickest way to end up bankrupt. You only have to be wrong once for your broker to send you that fateful call/email. A common number for the average individual investor is to invest 20-33 percent of your trading account as a maximum in any single stock/sector/industry.

Choose wisely: If I own shares of Apple, buying shares of Dell is not a smart idea. Because Apple and Dell are both tech-related, they are likely to move in unison. If one tanks, the other is more likely to sell off than a non-tech stock. This is not what you want in diversification.

An often forgotten gem is that directional trades can also be used to diversify your portfolio. If you believe that the current rally is running out of steam, you can diversify your portfolio by taking short positions in weak stocks (or throwing a few dollars in FAZ for risk-taking day traders). This way, you are not overexposed to the long side in case the market gaps down or heads lower in a hurry.

What if I don't have enough to diversify?

There is never a good time or an excuse to put all of your money in one stock, even if you have a small amount of money. If you don't have enough money to diversify (usually less than $500) then you might want to stick to buying shares of a mainstream ETF like the SPY, contemplate a Dividend Reinvestment Plans (DRIP) or just sit out of the markets and test out a simulator until you have more money to play with.

Conclusion

Diversification is simply an admission that you cannot guess the market with 100 percent accuracy and that you care about your money. Even the richest, most successful traders and investors in the world choose to diversify. Feeling undercapitalized at one time or another is not an excuse to over invest in a stock/sector/industry. In fact, the key to longevity in the market is to ignore the urge to do this, instead building good habits and compounding your profits.