Why It’s Important to Diversify Your InvestmentsSubmitted by Sound Financial Planning, Inc on February 4th, 2020
Even if new to investing, you are likely familiar with one of its most basic principles: ‘Don’t put all your eggs in one basket.’ The lesson in this old familiar saying is, if the basket were to topple over, all the eggs could spill out and break at once, leaving you with nothing. By putting your eggs in a variety of baskets, you can help seek to protect your stash against total loss.
When applied to investing, this idea is known as diversification, and the goal of diversifying your investments is to protect your nest egg from the volatility of the market while you are growing it. Please note that there is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not protect against market risk.
What Is Diversification?
When you diversify your investments, even if one investment dips or fails at any given time, your other investments may remain strong, potentially lessening your overall loss. In other words, putting all, or the majority of your money in a single investment is something you want to avoid because it’s extremely risky.
Diversification is an investment strategy that savvy investors employ in seeking to reduce risk and maximize return, especially for long-term investments such as retirement accounts. It works by spreading your risk exposure across multiple assets and among different asset classes. This strategy can potentially be effective if the securities in the portfolio are not correlated, meaning they respond differently, often in opposing ways, to market influences. For example, when bond prices fall, stock prices tend to rise, and vice versa.
The market is full of ups and downs and there is always risk involved. If you play it too safe, you’re likely to miss out on the benefits of market gains, but if you take too much risk, you could find yourself in trouble. Simply put, you should diversify your portfolio if you want to increase your odds of pursuing investing success.
How to Diversify Your Portfolio
Now that you know what diversification is and why you should do it, the next step is to understand what your different options are. When suitable, it’s best to diversify both across asset classes and within asset classes.
Diversification Across Asset Classes
When people are first introduced to the idea of diversification, they may believe that buying stock in a range of industries and geographic regions is sufficient to preserve their money. While this step is part of the equation, a properly diversified portfolio also contains investments in multiple asset classes.
An asset class is a grouping of investments with similar characteristics that are subject to the same regulations. The main asset classes include equities (stocks), fixed income (bonds), cash and cash equivalents, and real estate and commodities.
Stocks tend to be growth-oriented but typically have a greater degree of risk in the short-term. Bonds are typically safer and lower-risk, potentially providing stability to your portfolio. Cash and cash equivalents, such as money-market funds and certificates of deposits (CDs) tend to earn a better return than savings accounts with what’s considered negligible risk. Real estate investments historically have performed well during periods of high inflation and tend not to follow patterns of stock or bond market movements.
To be truly diversified, your portfolio will need to hold more than one kind of asset class, and ideally, you will want to consider holding assets across the four main asset classes.
Your appropriate asset class mix will depend on a number of factors including your risk tolerance and investment horizon, which often depends on your age. For example, at 40, you might choose to put 70% of your investments in stocks because you have more time to recover from potential losses before retirement. At 50, you might want to reduce your stock allocation to 60% of your portfolio and increase your lower-risk investment allocation.
Diversification Within Asset Classes
In addition to diversifying across the different asset classes, a solid diversification strategy also includes having different holdings within each investment asset class. The purpose of diversifying within asset classes is the same as diversifying across asset classes—to spread exposure and potentially minimize your risk.
One of the simplest and most popular ways to diversify within an asset class is through mutual funds, which pool money to invest in many different companies automatically. In fact, if you are already invested in mutual funds through your company’s 401(k), for example, you may not have realized you were participating in this common diversification strategy.
When it comes to diversifying, the right mix for you as an investor depends on your time horizon and risk tolerance. At 30 years old, you have time to take more risks than you do at 55, when your risk tolerance will be much lower and retirement closer.
Diversification is an important part of a strong investment strategy. If you don’t feel confident that you can diversify your own portfolio effectively, contact a qualified experienced financial advisor for help.
William Morrissey, CFP®, AEP® is the Founder of Sound Financial Planning, Inc, (SFP) and acts as the firm’s President. SFP offers client-centered, fee-only financial planning services, and investment advice to individuals, families, and businesses in Northwestern Washington. Learn more about them at soundfinancialplanning.net.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate, and is intended merely for educational purposes, not as advice.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Stock and mutual fund investing involves risk including loss of principal.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.