Filed under: Getting started, Comfort Zone Investing

Ted Allrich is the founder of The Online Investor and author of the just released book: Comfort Zone Investing: Build Wealth And Sleep Well At Night. In this weekly column, he’ll offer advice to investors who are just getting started.

I read the other day that according to a survey taken by a prestigious investment firm, most investors have two or three stocks. That’s a frightening statistic. Why? Because if you have the wrong two or three stocks, you’re in for a very difficult time.

Since the content of this column is for non-professional investors, it’s very important to realize that diversification is the key to happiness when it comes to investing. (Professionals will often concentrate in one industry, but they know it’s much riskier with commensurate rewards and are trained for that investing niche.) While diversification won’t make you rich fast, it won’t make you poor fast either.

You aren’t running a sprint when you invest. You’re in a marathon which at times feels like a triathlon. You don’t care about next week; you care about 10, 20 or 30 years from now. you want a large amount of money when you retire. Diversification will give you better odds of having that than a concentration of a few stocks.

The problem with owning one, two or three stocks is that the odds are against you having the right stocks, especially if all of them are in the same industry. If you owned three of the homebuilding stocks a year ago, and still own them, you don’t feel so good right now. Or if you owned three biotech companies, you’re feeling kind of sick. Many other industries also qualify for illness inducing investing. So the way to stay healthy and wealthy is to make sure your portfolio is filled with all kinds of stocks, not just one or two from one industry. And not just any stocks.

You need to buy non-correlated stocks, ones that move for different reasons. For example, financial service stocks are affected by interest rates. If you own a bank, a thrift, a credit card company, an insurance stock and a mortgage company, you have several stocks but no diversification. Every one of these is going to feel it when interest rates go up (bad), or down (good). What you want are several stocks and mutual funds that aren’t dancing to the same music.

For example, if you owned a gambling stock, a financial services company, a consumer stock, a drug stock, a biotech, a mutual fund specializing in foreign investments, a gold stock, an oil stock, and a toy manufacturer, you’d have good diversification. Some of those will move together, especially if there is a general economic slowdown. But they all won’t move downward at the same pace. The ones with better earnings will, in fact, go up. And that’s what you’re looking for: Stocks that will move up or down at different parts in an economic cycle.

So if interest rates go higher, the financial services stock will not increase earnings as business slows. But rates will have no effect on the drug stock, the biotech, the mutual fund with foreign holdings, or the consumer stock. Rates may dampen the oil stock a little but not much.

There are many combinations of stocks that qualify for a well diversified portfolio. To pick the right ones, keep in mind what will affect each industry. Interest rates are the biggest factor. Think about what will happen when rates go up or down and how your stocks will change when that happens. Think about where the economy is in cycle. Are we near the end of an expansion period, the beginning of a boom, or is there a recession looming?

As you make your best guess as to where we are economically, you’ll begin to fill your portfolio with some stocks that will prosper during the next several months or years based on your forecast as to what the economy will do. Then you’ll add stocks that aren’t going to move as much as those stocks because they won’t be affected as much by where the economy is or where it’s going. So first, get a good macro-economic scenario, then start putting together a well diversified portfolio. As I said above: You’ll get richer slower, but you won’t get poor faster. And you’ll sleep better.

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This entry was posted on Saturday, August 11th, 2007 at 12:23 pm and is filed under Stocks Money News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.