What’s all this talk about “diversification”?
Most individuals are familiar with the adage “don’t put all your eggs in one basket.” Although it sounds cliché, this is fundamentally the principle behind diversification.
All investments, by their nature, involve some degree of risk. At the same time, all investment risks are not equal. The primary purpose of diversification is to reduce the degree of investment risk in a portfolio.
WAYS TO DIVERSIFY
While many people feel that owning a “safe stock” (e.g., Coca-Cola or P&G) is a good idea, a sudden turn in the market, a lawsuit or slumping sales can cause the value of their “safe stock” to fall drastically. Then, one might think, diversifying by investing in multiple stocks can reduce their risk. In some respects this is true, however, the fact that you own various stocks doesn’t necessarily mean that you’re diversified. Your investment portfolio may contain similar types of stocks (e.g., consumer products, consumer discretionary and travel). Similar stocks are likely to react the same way to market stresses and therefore do not decrease the overall risk in the portfolio.
Diversifying by adding bonds can provide a cushion against market downturns. Bonds are debt instruments. They are agreements by the bond issuer to pay a stated interest rate to the investor. Traditionally, bonds are considered less volatile than stocks and behave differently than stocks. Just like stocks, there are varying types of bonds, and similar bond issues will react the same way to interest rate moves.
Who broke my crystal ball?
How’s an investor to know which type of stock or bond to select? Should you select large company stocks, international stocks, long-term bonds, corporate bonds, government bonds, etc.?
The Callan chart that follows shows 10 different market indices ranked in order of performance across the years 1995 through 2014 (i.e., best performers at the top of the chart, worst performers at the bottom of the chart). The chart clearly illustrates the difficulty in determining which part of the market will be the best in any given year.
Knowing that chasing last year’s best performers is almost always a gamble, the most prudent thing an investor can do is to choose to “have a horse in [almost] every race.” The idea is to distribute one’s investments among several asset classes. By doing this, you can be reasonably certain that you will have some exposure to the best performers.
What about mutual funds?
Mutual funds do provide diversification by virtue of the fact that they generally hold shares of many different companies. But, like similar stocks, mutual funds that invest in similar companies are not diversified in the larger sense. A fund that invests in domestic large-cap blend companies is going to behave in a similar manner to the S&P 500 index.
Mutual funds have specific investment objectives and invest accordingly, so using different funds with varying investment objectives will diversify a portfolio.
What is your time horizon and risk tolerance?
Two factors that go hand in glove with regard to diversifying your portfolio are your time horizon and risk tolerance.
Your time horizon is the period over which your assets will be invested, and (contrary to what some believe) does not end when you begin to withdraw the money. A person in their 20s may have an investment time horizon of over 60 years, while a 60-year-old may have another 30 years to be invested. All things being equal, the longer your investment-time horizon, the more risk your portfolio can stand. Conversely, the shorter the horizon, the more conservative your portfolio should be.
The second factor that affects the manner in which your portfolio should be diversified is personal risk tolerance. If you are naturally risk-averse, then your portfolio should be more conservative than someone who is a naturally more aggressive investor.
Both of these factors should be carefully considered when it comes to deciding on the best way to diversify a portfolio. A naturally conservative investor whose portfolio is too aggressive may be driven by emotion to abandon the portfolio at exactly the wrong time, that is, when the market is down. An aggressive investor whose portfolio is too conservative may be driven to take on more risk as the market approaches its top.
Some investors believe that a diversified portfolio means that their account value will not fluctuate. Of course, this is not the case. In reality, mathematical analyses of portfolio returns show that it is the fluctuation (or volatility) that is a large driver of long-term return.
No one can know what returns their investments will yield in the future. Indeed, past performance is not a guarantee of future results. But historically, a diversified portfolio reduces exposure to market volatility, smoothing out the peaks and valleys. It’s important to remain focused on your long-term objective when investing. Periods of low performance should be expected from time to time, but in the long term, they are relatively insignificant.
Is Your Portfolio Diversified Enough?
If you are not sure whether your portfolio is diversified enough, or if you have questions on the best diversification strategy for your situation, request a 20-minute Q&A session with Retirement Advisors of America for answers to these and other questions.
Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by Retirement Advisors of America following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, Retirement Advisors of America accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.