Recently a new breakfast joint opened up in my town. During my first trip there, I was pleasantly surprised to see that they also have a lunch menu. That meant in addition to delicious breakfast sandwiches; there were also traditional lunch options like soups, salads, and BLTs.
I’m all about a solid breakfast sandwich. But, sometimes, when it’s around noon, you just want a traditional standby.
As I waited for my order one-day last week, I thought that offering variety is a trademark of all successful businesses. There are clothing companies that sell bathing suits and sweatshirts. Domain registrars allow you to buy a domain name and web hosting.
For business owners, selling an assortment of options just makes sense. By offering various services or products, you can tap into more markets and boost your profitability. And, when you sell many options — you’re also reducing a risk — meaning you aren’t just relying on a sole offering.
When it comes to investing, you should also embrace variety. In this case, diversifying your investment portfolio so that you aren’t “putting all of your eggs into one basket.”
But, what exactly is diversification? Why should you do it, and how can you get started?
What is diversification?
Diversification is an investment strategy where you own a variety of assets that will perform differently over time. The idea is that it provides security and mitigates risk. If an investment fails or underperforms, you won’t lose everything.
However, a diversified portfolio shouldn’t contain too many options. “Diversification is a protection against ignorance,” according to Warren Buffett. “[It] makes very little sense for those who know what they’re doing.”
“It is unwise to spread one’s funds over too many different securities,” said Bernard Baruch. “Time and energy are required to keep abreast of the forces that may change the value of a security. While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.”
In other words, while many financial planners, fund managers, and individual investors recommend that you diversify, you also shouldn’t spread yourself too thin. Ideally, a diversified portfolio should limit yourself to about 15 to 30 different investments.
Additionally, the portfolio should be composed of different types of investments that will yield higher returns and pose a lower risk. That means some will remain study, will others will rise rapidly depending on the economy’s performance.
It should also contain stocks across a variety of industries. And in addition to stocks, your portfolio may also include bonds, index or mutual funds, CDs, savings accounts, and real estate.
“If you invest and don’t diversify, you’re literally throwing out money,” stated Jeff Yass. “People don’t realize that diversification is beneficial even if it reduces your return.”
Why is this the case? “Because it reduces your risk even more,” added Yass. “Therefore, if you diversify and then use margin to increase your leverage to a risk level equivalent to that of a nondiversified position, your return will probably be greater.”
In short, when you diversify, your reducing risk. Does that mean you’re 100% risk-free? Of course not. Whenever you invest, there is some level of risk involved.
“The goal of diversification is not necessarily to boost performance—it won’t ensure gains or guarantee against losses,” explains the folks over at Fidelity. “Diversification does, however, have the potential to improve returns for whatever level of risk you choose to target.”
“To build a diversified portfolio, you should look for investments—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction and to the same degree,” states the Fidelity team. As a result, “even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much.”
What’s more, diversification also has long-term value. For instance, “during the 2008–2009 bear market, many different types of investments lost value at the same time, but diversification still helped contain overall portfolio losses.”
How to diversify your investments.
Want to diversify your investment portfolio? Hopefully, you’re roaring to get started. And you can do see by taking the following steps.
1. Spread the wealth.
As already mentioned, when building and optimizing your investment portfolio, you don’t want to throw all of your hard-earned cash into one place. Instead, you want to spread it across multiple sectors. In addition to reducing risk, each category serves a unique purpose.
- Stocks, particularly mutual funds, are already diversified and can steadily grow your portfolio.
- Bonds can bring in income since they’ve historically yielded between 5–6%.
- Cash provides security and stability.
- Real estate investment trusts (REITs) provide dividend-based income, competitive market performance, liquidity, and inflation protection.
- International investments are another proven way to grow your portfolio and maintain buying power.
Some advisors more also recommend CDs and commodities like gold and silver. But, the main takeaway is not to spread yourself too, think. Focus on quality, not quantity.
Moreover, financial expert Chis Hogan suggests that you evenly spread your investments into the following four types of mutual funds to protect yourself against losses.
- Growth and income. These are established and predictable funds from companies like Apple.
- Growth. Daily stable funds consisting of stocks from growing companies.
- Aggressive growth. Unpredictable and high risk. But could return a high reward.
- International. Funds are made up of stocks from other countries. The idea is that if the market takes a downturn in the States, you have stocks in companies overseas that are performing well.
2. Use asset allocation or target-date funds.
“Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash,” notes Investor.gov. “The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.”
If you’re curious, the time horizon “is the expected number of months, years, or decades you will be investing to achieve a particular financial goal.” If you have a longer time horizon, you may be more willing to riskier or more volatile investments.
The reason being is that you “can wait out slow economic cycles and the inevitable ups and downs of our markets.” On the flipside, “an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.”
Confused? Don’t be. In a nutshell, allocation funds are simply mutual funds that contain both stocks and bonds. Most target-date funds come in five-year increments. The advantage with these is that it is basically a “set-it-and-forget” savings option — usually in an Annuity, 401(k) or Roth IRA.
How much should you allocate?
If you want a more exact figure, here’s an example you can follow courtesy of NOLO:
“Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. So, “if you’re 20 years old, put 80% of your assets in stocks; 20% in bonds. (Most 401(k) plans contain both stock and bond offerings; you can also buy these investments through an IRA.)”
Next, you want to adjust percentages if using the example above:
- “Invest 10% to 25% of the stock portion of your portfolio in international securities. The younger and more affluent you are, the higher the percentage.”
- Shave 5% off your stock portfolio and 5% off the bond portion, then invest the resulting 10% in real estate investment trusts (REITs).”
The result? The “hypothetical 20-year-old would have an emergency fund, and the remaining assets would be split 75% stocks (of which 25% were international), 15% bonds, and 10% REITs.”
3. Regularly manage your plan.
Finally, because diversification in investing can get complicated, you should work with a financial advisor. Moreover, just like your vehicle, it also requires regular maintenance by:
- Monitoring. Frequently checking in on your investments periodically so that you’re aware of any changes in strategy, performance, and risk. You also want to be on the lookout for any monthly or transactional fees you’ve been charged.
- Rebalancing. Despite the misconception, diversification isn’t a one-time task. As such, revisiting your portfolio allows you to make sure assets and adjust your mix. You may want to do this at least twice a year. But, services like Bloom and robo-advisors, including Betterment, will automatically do this for you.
- Refreshing. And, at least once a year, see if your plan is still aligned with your financial goals. For example, if the market condition has taken a hit, you may want to sell some of your assets.
The bottom line.
Investing is a proven way to make money that you can use later, line in retirement. But, it can also be risky. By keeping your investments diversified, you can grow your money without worrying about potentially losing it all.