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Titled: The Strategy of Variety in Common Stock Investment
The Strategy of Variety in Common Stock Investment
Article Summary: "One rotten apple spoils the barrel." But in a barrel full of diversified stock, one fine one can offset several bad ones. The mathematical trick here is that the price of a bad performer can drop only so far, zero being the bottom limit, whereas a successful stock has no top limit.
Among fixed-dollar investments variety may have little point. On U.S. savings bonds, the possibility of the Government failing to pay dollars as promised is too slight to bother about, and the same is true of a deposit in a bank insured in F.D.I.C. So to the extent that a man desires that sort of investment, there may be no reason for buying more than one variety.
Common stock is different. When an investor buys stock in a good-sized corporation, ordinarily he is not interested in attempting to gain control of the corporation, and this eliminates the necessity for concentrating in the stock of one company. But what difference does it make to his investment whether he concentrates or diversifies in common stocks?
The aspect of the stock market that attracts the most attention is the change in value of the prominent indexes, or averages. "The Dow-Jones Industrial is up 27 points." Such statements give the impression that the values of all stocks move in a similar fashion. To some extent, the prices of stocks do tend, at any one time, to move in the same direction.
In a period of increasing prosperity or optimism, most stock prices rise, and in a time of shrinking profits or of pessimism, they go down. But at the same time, the price of any one stock is also affected by what speculators and investors know or guess about that company in comparison with others.
Assuming that in January of 2007, we make a $1,000 investment in each of the last year's top 100 performing stocks of a specific market. After 3 months we found that on the worst-performing stock the value had gone down to $500, while on the best it had risen to $5,000, and on the other 98 stocks the value ranged all the way between these extremes.
Most of the stocks rose considerably in price, because the time period included a stock-market boom. But the main point of the study was to show how individual stocks differ from one another in their price movements, and this tendency is present no matter whether the general market trend is down or up or level.
An optimistic reader doubtless will react to our comparison of results, by thinking, "Obviously the thing to do is to buy only the stock whose price will rise the furthest." A buyer is justified in taking this attitude, provided he realizes he is gambling, or he is egotistical enough to believe he knows how to forecast the trend in price of the stock he selects.
Of course a gambler or an egotist may be right sometimes; the real test of his investing ability is how he comes out in the total of all his moves over a period of, say, twenty years.
A timid reader's reaction to the varied results among these stocks may be: "If some stocks actually drop in price, while the average market level is going way up, then evidently when the general level drops, some stocks show just about a total loss. If I buy stock, it might prove to be one of the bad ones, so I won't buy any." This fear of bad results might be justified if a buyer were limited to just one, or even to just a few stocks. But a timid reader needs to get acquainted with the possibilities of averaging by diversification.
Instead of putting $1,000 into just one stock, let us imagine that an investor divided it up putting $10 into each of the 100 stocks in our list. Such small-scale buying of these exchange listed stocks is impossible, we know it is possible to participate in a portfolio of stocks through buying units of a mutual fund which invest in quality stocks of that market. So after 3 months of investing $1,000, the value of the 100 stocks was $1,500. Obviously this value was far below the result with the best performer mentioned above, and it was also far above the worst one. In considering this result, remember that it was merely the average of the list of top company names over last year, with no attempt at selection for sustained growth and future prospect.
It is said: "One rotten apple spoils the barrel." But in a barrel full of diversified stock, one fine one can offset several bad ones. The mathematical trick here is that the price of a bad performer can drop only so far, zero being the bottom limit, whereas a successful stock has no top limit. So the good ones tend to outweigh the bad ones.
The key here is to diversify to manage your risk and win consistently. Dividends are affected by averaging in the same manner as prices are. But the discussion here is limited to prices, because they move up and down faster and farther than dividends do, so that the effect of diversifying is more obvious.
Article Source: http://www.upublish.info
About the Author:
John Kiing
John Kiing is a freelance writer and stock investor in U.S and Asian stock markets. He writes for 101StockInvestments.com - a FREE resource center for novice or seasoned market investors. This article could be distributed digitally as long as the website links remain intact.
Keywords: Common+Stock+diversification, stock+diversifying, stock+portfolio+diversification, stocks+strategy
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