Diversification

Diversification is another important aspect of your money management plan.  It is a risk management technique where you have an assortment of different types of assets in your portfolio.  The theory behind this is that by investing in a number of uncorrelated assets you will lower the overall risk of your portfolio while increasing it's return.  Although diversification is mainly though of as a technique for long term or swing traders it also is applicable to a day trader.

To have true diversification in your portfolio, you should have a portion of your assets in the various asset classes like stocks, bonds, commodities, options, real estate, cash, etc.  You should also diversify by industry or sector.  An example would be if you like the transportation sector, have an airline, a railroad and a trucking stock, not 3 airline stocks.  You should also diversify by company size and classification.  You would not want to invest in 10 small company stocks or 10 growth stocks.  For bonds, you would want to diversify based on maturities and also category.  You would not want to buy all bonds with 10 year maturities.  You would also not want to buy only corporate bonds and exclude Treasury bonds.  You should also try to diversify by region.  You should mix in some foreign (i.e. non US) investments into your portfolio.  An easy way to diversify is to buy ETFs (exchange traded funds) instead of individual securities.

The goal is to invest in securities that are not highly correlated to each other.  High correlation means that the securities seem to trend in the same direction or react the same way to an event.  So for example you donít want to have 5 positions in semiconductor stock.  Even though this means that you donít have a large portion of your account in one stock so it is essentially diversified from that perspective, you are overexposed to that sector so it is similar to having just one position in a single semiconductor stock.

For the long term or swing trader, you should have a minimum of 10 positions but no more than 30. 

For the day trader, you should have at least 3 positions but probably no more than 10 positions at any one time.  Any more than that and you cannot properly manage your positions.  You should start with a the 3 positions and then as you get better at trading, increase the number of positions you hold at any one time.

Remember if you add positions and your performance declines, cut back to fewer positions until your performance improves.

Also be aware of over diversification.  To much diversification can be a bad thing because your are being a jack of all trades and a master of none.