Diversification for Beginners and Experts
Some people oppose diversification, arguing that it is more profitable to become expert in a single field than a “jack of all trades” in several. This can be true.
When an investor's level of knowledge and experience increases, he may choose to narrow his investment field to some degree. This allows him to focus his talents and energy on that which he enjoys the most and is best at.
There are many stock and derivative traders who have a much narrower investment field than you might expect. However, at the same time, I must emphasize that these people would rarely, if ever, put all their money into a single venture. For example, an experienced stock investor may have a portfolio that consists only of four or five stocks (as opposed to 10 or 12). However, this person is probably analyzing these stocks in great detail and owns a property or two as well.
Diversification is a personal subject and everyone will arrive at their own comfort level, but never underestimate the protection it can afford you and your family.
It’s important to be able to work out which assets are going to be profitable for you and meet your risk and return objectives. Some people prefer high-risk ventures that are all or nothing, while many others prefer more “normal” investments that have consistent and stable returns. The real trick is knowing your own strengths and weaknesses, as well as those of your investments. Knowing yourself and your investments that's how money is made.
Investing in Publicly Listed Companies
Let's first put some stock investment myths to rest and then focus on how you can use the stock market to enhance your wealth. For one, the stock market is not necessarily a high-risk investment. As with all other investments, it depends on what you invest in and how you do it.
Stocks can be classified into 3 main groups: low risk, medium risk and high risk.
Low risk stocks are quality companies that have a strong trading record and meet your personal selection criteria. These are usually “blue chip” companies, although good quality stocks sometimes exist outside the “blue chip” arena.
Medium risk stocks may be medium-sized companies that have solid growth potential, but may not be as established as the blue chip companies. Often the returns will be greater on medium risk companies than on low risk stocks.
Speculative stocks in small companies represent a high degree of risk, especially to new investors. These are typically stocks in small companies that are about to “make it or break it.” Dabbling in speculative stocks can be akin to gambling if there is no set investment strategy. Even with the right knowledge and strategy, returns from high-risk stocks are uncertain.
The key thing to remember with stock investments is that your choice of stocks can be arranged to suit your investment needs and risk profile. This choice and flexibility is one of the great benefits of stock investments.
For example, if John and Mary need an investment with strong capital growth over time, a portfolio of diversified and medium-risk stocks can be chosen. On the other hand, if Mary's mother wants to invest to generate an inflation-proof income stream, she can search out low risk stocks with an emphasis on high yields (“high yield” means a high return earned by an investment.)
Apart from investing in basic stocks, investors can also access other aspects of the market. Some of the other investment vehicles include:
• Mutual (Managed) Funds
The options and futures markets comprise the “derivatives” market. This is because they are stock-based investments derived from the stock market.
Each of these investment tools can be used to make money, although they all operate differently and have different levels of risk and return. The derivative markets tend to be more specialized and if not managed properly, can represent high risk to the novice investor.
Investors who do not wish to personally manage their stock investment often use mutual funds. By investing in a mutual fund, investors simply hand over their money and allow the fund managers to run the investment. All the money is pooled together and investors then benefit from the larger, professionally run investment.
The stock market is likely to be a key part of your wealth creation strategy. Excellent returns can be made through stocks, and diversification is easily achieved.
You are a vulnerable investor when your wealth and income level can be easily influenced by events outside of your control. A diversified portfolio protects you from vulnerability.
Some Common Terms You Need to Know
The stock market has historically been filled with jargon. Most of it isn't that difficult to understand once you get the hang of it.
A stock is a share of ownership in a company. When you own stocks you effectively become part owner of the company. You will thus share in both the profits and the losses of the enterprise.
A company pays a dividend to the stockholders out of the company’s profits. It is easiest to think of it as the stockholder's portion of the profits. However, the company’s management decides how much of the profit is paid to stockholders and how much is retained within the company. Not all companies pay dividends, but those that do either pay cash or additional shares of stock.
This is the period between the declaration of a dividend by a company or mutual fund and the actual payment of the dividend. On the ex-dividend date, the price of the stock or fund will fall by the amount of the dividend, so new investors don't get the benefit of it. Companies that have gone “ex-dividend” are marked by an “X” in the newspaper listings.
A prospectus is the official document distributed to the public announcing the issue of stocks in a company or fund to be listed on the stock exchange. The document outlines the company's activities, its expected performance and the potential risks and returns. Investors who are interested in subscribing to the issue must fill in the application form at the back of the prospectus, attach the relevant money and send it back to the issuer. When a company is first listed on the stock exchange it must go through this procedure, often called a “float.” If a listed company wants to expand the number of stocks currently on issue, it must follow this procedure again and distribute a prospectus.
A bull market is one that is in an up-trend. A bull market refers to a rising market where prices and interest in the market are both strong.
A bear market is a pessimistic market where prices and interest in the market are falling.
In future articles I will outline specific stock market investment strategies that you can employ to improve your chances of high returns. Next week I'll introduce other asset classes such as the property market and small business investment.