DIVERSIFICATION · an investment strategy, not a guaranteeRULE OF THUMB · don't put all your eggs in one basketSECTOR · a group of stocks, often in one industryRISK TOLERANCE · how much loss you can acceptINDEX · measures a market from a starting pointPORTFOLIO · a collection of investmentsDIVERSIFICATION · an investment strategy, not a guaranteeRULE OF THUMB · don't put all your eggs in one basketSECTOR · a group of stocks, often in one industryRISK TOLERANCE · how much loss you can accept
Don't put all your eggs in one basket. This session shows you how to read a portfolio for balance, and how to build one that can survive a bad day in any single sector.
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Background
Why Diversify?
Because it is very difficult to accurately predict how any one company will perform over time, diversification is a strategy that helps protect your portfolio. It is a widely used and highly successful way to reduce risk.
Most financial planners agree with the admonition: "don't put all your eggs in one basket." By investing in different types of stocks, bonds, and mutual funds, the value of your entire portfolio should not be wiped out if one investment fails.
The exercises in this session ask you to look at real portfolio structures, decide which ones are spread across enough different industries, and then practice the math that sits underneath the word "diversified": percentages, proportions, and how to read a chart that shows where money is really concentrated.
Key Terms
Vocabulary
Tap a card to flip it and reveal the definition.
Diversification
An investment strategy in which you spread your investment dollars among industry sectors.
Index
Reports changes, usually expressed as a percentage, in a specific financial market. Each index measures the market from a specific starting point. Some indexes are the Dow (NYSE), S&P 500 (NYSE), and Russell (NASDAQ).
Industry
A group of companies that make the same products, for example pharmaceutical companies.
Portfolio
A collection of investments owned by one individual or organization.
Risk
The chance of losing all or part of the value of an investment.
Risk Tolerance
An individual investor's ability to accept loss of some or all of the money they have invested, based on factors including age, financial stability, and the time before the invested funds are needed.
Sector
A group of stocks, often in one industry. The performance of any single stock in a sector can be measured against the performance of the group. Pharmaceutical companies are considered part of the health care sector.
Goals
Performance Objectives
By the end of this session, you will be able to:
Create a diversified portfolio selecting stocks from at least six industries.
Conduct research on investment options, and write a summary of your findings.
Interpret company and industry charts to determine which investments to make.
Define diversification, risk tolerance, industry, and index.
Suggested materials for live research (as listed in the original worksheet):
Note: treat any prices or figures you find on these sites as current only as of the day you look them up.
Activity Sheet 1
How Diversified Are These Portfolios?
From the three portfolios below, which one is the most diversified? Explain your reasoning before revealing the model answer.
Portfolio A
FISV · 100Business Software
TD · 100Bank
ADES · 100Specialty Chemicals
TRB · 100Publishing / Newspaper
TW · 100Insurance
ESRX · 100Health Services
RAIL · 100Railroad
Portfolio B
JPM · 200Bank
AAPL · 150Personal Computer
INTC · 200Semi-conductor
GOOG · 100Internet Search
MSFT · 300Software
SBUX · 150Specialty: Eateries
DELL · 300Personal Computer
HD · 250Home Improvement
Portfolio C
SBUX · 500Specialty: Eateries
TIF · 200Jewelry
BK · 100Banks
GOOG · 100Internet Search
CSK · 100Paper Products
NCC · 100Banks
UNS · 700Electric: Utilities
WMT · 300Discount: Variety
PORTFOLIO A
Answers may vary here, the point is to think deeply about the reasoning, not just name a winner. Generally speaking, Portfolio A is considered the most diversified since it spans a genuinely varied set of industries: business software, banking, specialty chemicals, publishing, insurance, health services, and railroads. Portfolio B is not as diversified because several of its holdings (personal computers, semiconductors, software) sit inside the same broad technology sector. Portfolio C is not as diversified because several of its holdings sell personal luxury items or consumer goods (eateries, jewelry, paper products, discount retail) that tend to move together with consumer spending.
Now it's your turn
Select one of the three portfolios above and diversify its holdings using the rule given in the original worksheet: you cannot diversify just by adding more companies. Assume all stocks are priced the same. After you sell 700 shares of a holding, you can buy 300 shares of one company and 400 of another. Explain every change you make.
Show a worked example
SAMPLE ANSWER
I would work on Portfolio B. I would sell the 300 shares of Microsoft and buy 200 shares of Newmont Mining (materials) and 100 shares of New York State Gas & Electric (utilities). I would then sell the 300 shares of Dell and buy 100 shares of ESRX, a health services stock, and 200 shares of Toyota (autos). These changes pull the portfolio out of a technology-heavy concentration and into materials, utilities, health services, and autos, four sectors it did not touch before.
Activity Sheet 2
Industry / Sector Research
Grouping stocks into sectors and industries makes it easier to evaluate stocks within the same industry and assess the economic strength of that industry. Go to a stock research website and find one stock in each sector below, then record the ticker, price, and products or services.
Sector
Company Name
Ticker
Price
Products / Services
Basic Materials
Consumer, Cyclical
Consumer, Non-cyclical
Energy
Financial
Healthcare
Industrial
Technology
Telecommunications
Utilities
Show the original worksheet's sample answer key
This is old, illustrative data only, not current information. These are the exact company, ticker, and price entries printed in the original answer key. I cannot confirm what year they date from, but the prices are clearly from some past point (for example Con Edison at $80.30 and Exxon Mobil at $66.47), so please treat every figure below as a historical example of how to fill out the table, not as today's numbers.
Sector
Company Name
Ticker
Price
Products / Services
Basic Materials
Alcoa
AA
$29.32
Aluminum
Consumer, Cyclical
Time-Warner
TWX
$16.21
Entertainment
Consumer, Non-cyclical
Proctor & Gamble
PG
$56.44
Household products
Energy
Exxon Mobil
XOM
$66.47
Oil and gas
Financial
Wachovia Bank
WB
$52.40
Banking and financial services
Healthcare
Amgen
AMGN
$69.28
Biotechnology
Industrial
Hanson PLC
HAN
$61.28
Cement
Technology
First Data Corp
FDC
$41.11
Business software and services
Telecommunications
Verizon Communications
VZ
$33.73
Phone and related services
Utilities
Con Edison
CEDNM.OB
$80.30
Electric and gas service to the New York City area
Activity Sheet 3
How Diverse Is Your Portfolio?
List your own portfolio, or a planned one, below. Use market cap to gauge risk tolerance: a Small Cap company is under $2 billion, a Mid Cap company is $2 billion to $10 billion, and a Large Cap company is over $10 billion. Smaller companies tend to carry higher risk and more price volatility.
Ticker Symbol
Shares Held
Company
Risk Tolerance
On a scale from 5 to 1, where 5 is the most diverse, rate your own portfolio, and be ready to explain the rating.
Show a sample completed sheet
SAMPLE ANSWER
Ticker
Shares
Company
Risk Tolerance
ESLR
300
Evergreen Solar
High, small cap
TM
100
Toyota
Low, large cap
VLTS
250
Valentis Inc
High, small cap
SDA
400
Sadia S.A.
Medium, mid cap
Self-rating: 4 out of 5. This mixes cap sizes and industries but is still a small, four-position portfolio, so it is diversified relative to its size rather than fully diversified in an absolute sense.
Action Plan
Review the holdings table above and decide on your investment strategy. For each holding, or each planned holding, record:
Investment type: stock or mutual fund.
Why you selected it: performance versus other companies, market capitalization, potential for moderate and sustained growth, or another stated reason.
Risk level: high, medium, or low.
Ticker symbol and number of shares owned.
Answers here will vary by portfolio. There is no single correct action plan, the goal is that every choice is tied to a reason you can defend.
Activity 4 · Thinking Algebraically
Calculating Percentages
To find what share of a portfolio sits in one category, divide the money in that category by the total value of the portfolio, then multiply by 100.
% in category = (money invested in category ÷ total value of investment) × 100%
Company
Size
Sector
Value
A
Mid
Industrial materials
$36,000
B
Small
Consumer goods
$7,000
C
Large
Media
$11,000
D
Mid
Utilities
$3,000
E
Mid
Consumer goods
$7,000
F
Large
Consumer goods
$21,000
G
Small
Telecommunications
$1,500
H
Large
Industrial goods
$31,000
I
Small
Health
$15,500
J
Mid
Energy
$5,000
K
Large
Energy
$27,000
L
Mid
Utilities
$19,000
Q1
What is the total value of the investment above?
$184,000.00Sum of all twelve values.
Q2
Calculate the percentage of the total investment in each sector.
Industrial materials 19.57% · Consumer goods 19.02% · Media 5.98% · Utilities 11.96% · Telecommunications 0.82% · Industrial goods 16.85% · Health 8.42% · Energy 17.39%
I recalculated each figure directly from the table above (for example, industrial materials: $36,000 ÷ $184,000 = 19.57%) and they match the original answer key exactly.
Q3
Calculate the percentage of the investment in each size company.
Small cap 13.04% · Mid cap 38.04% · Large cap 48.91%
Q4
Construct a bar chart to show how diversified this portfolio is by sector.
Industrial materials
19.57%
Consumer goods
19.02%
Media
5.98%
Utilities
11.96%
Telecommunications
0.82%
Industrial goods
16.85%
Health
8.42%
Energy
17.39%
Q5
Construct a pie chart to show how diversified this portfolio is by cap size.
Small cap · 13.04%
Mid cap · 38.04%
Large cap · 48.91%
Activity 4 · Interpreting Statistics
Reading a Sector Breakdown
Below are three different investors' portfolios, shown as a percentage of holdings by sector. Study each one before revealing the answers.
Portfolio 1
Utilities
25.50%
Business services
9.06%
Energy
6.86%
Hardware
6.10%
Industrial materials
52.49%
All other sectors (Financials, Telecommunications, Media, Consumer goods, Health, Software, Consumer services) are at 0.00%.
Q1
How much more is this portfolio invested in industrial materials than in utilities?
26.99%52.49% − 25.50% = 26.99% more.
Q2
How much more is this portfolio invested in energy than hardware?
0.76%6.86% − 6.10% = 0.76% more.
Q3
Would you say this is a well-diversified portfolio, or not well diversified? Why?
MIXEDThis portfolio touches five different sectors, so on the surface it looks diversified. But over 75% of the money sits in just two of them, utilities and industrial materials, which makes it fairly one-sided in practice. Utilities is generally considered a lower-risk sector, which softens that concentration somewhat, but it does not remove it.
Portfolio 2
Utilities
1.48%
Business services
10.46%
Financials
4.02%
Media
8.54%
Consumer goods
20.72%
Energy
3.91%
Hardware
2.63%
Health
2.15%
Consumer services
25.32%
Industrial materials
20.77%
Q4
What sector does this investor have the most money invested in?
CONSUMER SERVICES25.32%
Q5
What sector does this investor have the least money invested in?
UTILITIES1.48%
Q6
Would you say this is a well-diversified portfolio, or not well diversified? Why?
WELL DIVERSIFIEDYes. This portfolio is invested across all ten sectors listed, and the top three sectors together account for only about 65% of the total, so no single sector dominates the way industrial materials did in Portfolio 1.
Portfolio 3
Telecommunications
98.86%
Industrial materials
1.14%
Every other sector is at 0.00%.
Q7
What sector does this investor have the most money invested in?
TELECOMMUNICATIONS98.86%
Q8
What sector does this investor have the least money invested in?
INDUSTRIAL MATERIALS1.14% (the only other sector with any holding at all).
Q9
Would you say this is a well-diversified portfolio, or not well diversified? Why?
NOT DIVERSIFIEDNo. Only two sectors are represented at all, and 98.86% of the entire portfolio sits in telecommunications alone.
Q10
If one sector of the economy falls sharply, which portfolio is at the greatest risk? Which has the greatest protection from a fall in one sector? Why?
RISK: PORTFOLIO 3 · PROTECTION: PORTFOLIO 2
Portfolio 3 is at the greatest risk. With 98.86% of its value in a single sector, a downturn in telecommunications would devastate the whole portfolio. Portfolio 2 has the greatest protection, since it is spread across all ten sectors and no single sector exceeds roughly 25%.
Activity 4 · Communicating Quantitative Information
Creating Charts to Represent Diversification
There are many ways to visualize a diversified portfolio. Below is one set of holdings and the charts that come from it.
Company
Cap Size
Sector
Investment Value
A
Small
Media
$6,000
B
Mid
Software
$11,000
C
Mid
Consumer goods
$10,000
D
Small
Consumer goods
$7,500
E
Large
Utilities
$36,000
F
Small
Business services
$12,000
G
Large
Utilities
$10,000
H
Small
Consumer goods
$4,500
I
Mid
Energy
$25,000
J
Large
Health
$27,000
K
Small
Media
$13,000
Q1
Next to each graph, write what information it presents.
Size of Companies (small $43,000 / 27%, mid $46,000 / 28%, large $73,000 / 45%)
Small · $43,000 · 27%
Mid · $46,000 · 28%
Large · $73,000 · 45%
This pie graph shows what percentage and dollar value of the portfolio sits in each company size, small, mid, and large cap.
Investment by Sector
Media
$19,000
Software
$11,000
Consumer goods
$22,000
Utilities
$46,000
Business services
$12,000
Energy
$25,000
Health
$27,000
This chart shows the percent and dollar value invested in each sector. The bar and pie versions present the same underlying numbers in two different formats, one is easier for comparing sectors side by side, the other is easier for seeing each sector's share of the whole at a glance.
Now practice on your own
Below is one portfolio to practice with. Use it to build three graphical representations showing diversification both by sector and by cap size.
Company
Cap Size
Sector
Investment Value
A
Mid
Consumer services
$8,500
B
Mid
Software
$9,000
C
Small
Software
$13,500
D
Large
Media
$20,000
E
Mid
Telecommunications
$15,000
F
Large
Software
$12,000
G
Mid
Energy
$9,000
H
Small
Software
$50,000
I
Small
Telecommunications
$7,000
J
Mid
Financial
$5,000
K
Small
Consumer goods
$9,000
Show computed totals and charts
VERIFIED AGAINST SOURCE ANSWER KEY
Total portfolio value: $158,000.
By cap size: small 50.32%, mid 29.43%, large 20.25%.
Small · 50.32%
Mid · 29.43%
Large · 20.25%
By sector: Consumer services 5.38%, Software 53.48%, Media 12.66%, Telecommunications 13.92%, Energy 5.70%, Financial 3.16%, Consumer goods 5.70%.
Consumer services
5.38%
Software
53.48%
Media
12.66%
Telecommunications
13.92%
Energy
5.70%
Financial
3.16%
Consumer goods
5.70%
More than half of this portfolio sits in software alone (53.48%), so despite touching seven sectors and all three cap sizes, it is not well diversified by sector.
Activity 4 · Tackling Complex Problems
Evaluating Diversification Over Time
Below are the holdings a team has in their portfolio.
Stock
Price per Share
Number of Shares
Cap Size
Z
$12.43
800
Small
Y
$79.20
125
Large
X
$49.74
240
Large
W
$20.68
390
Large
V
$26.51
225
Small
U
$5.21
2,700
Small
T
$17.53
950
Mid
S
$46.50
80
Mid
R
$21.14
450
Mid
Q1
What is the total value of their portfolio?
$89,765.05Sum of price × shares across all nine stocks. I recalculated this line by line and it matches the source answer key exactly.
Q2
Determine what proportion of their investment is in small-cap, mid-cap, and large-cap stocks.
Small cap 33.39% · Mid cap 33.29% · Large cap 33.31%
Q3
Would you advise them to diversify? Why or why not?
NO NEED TO DIVERSIFY FURTHERNot on cap size. The portfolio is already almost perfectly split three ways across small, mid, and large cap, and it holds nine different stocks.
Five months later, the stocks have changed in price
Stock
Price per Share
Number of Shares
Cap Size
Z
$18.30
800
Small
Y
$88.83
125
Large
X
$51.05
240
Large
W
$19.13
390
Large
V
$32.00
225
Small
U
$5.53
2,700
Small
T
$27.74
950
Mid
S
$45.05
80
Mid
R
$25.16
450
Mid
Q4
Recalculate the proportions of the investment in small-cap, mid-cap, and large-cap companies.
New total value: $108,866.45. Small cap 33.78% · Mid cap 37.92% · Large cap 28.31%.
I recalculated this total and each proportion independently and they match the source answer key.
Q5
Compare the portfolio's diversification now to its diversification five months ago.
Five months ago the split was almost exactly even at roughly 33% each. Now mid-cap has grown to 37.92% and large-cap has fallen to 28.31%, so the balance has shifted, mostly because the large-cap holdings (Y, X, W) grew more slowly in price than the mid-cap holdings (T, S, R).
Q6
What advice would you give the portfolio manager?
The portfolio is still reasonably diversified by cap size, and holding it as is would be a defensible choice. Keeping the split at exactly 33% for all three cap sizes at all times is not realistic, since prices move independently, so the manager should watch for a much larger drift (say, one category climbing above 45 to 50%) before treating a rebalance as necessary.