When it comes to smart investment decisions, professional advisors often talk about the benefits of diversification. It is a technique that can manage an investor’s exposure to risk by mixing a wide variety of investments within a portfolio.
The Bible even talks about something similar in Ecclesiastes 11:1–2: “Cast your bread upon the waters, for you will find it after many days. Give a serving to seven, and also to eight, for you do not know what evil will be on the earth.”
When a portfolio is diversified, the fluctuations of a single security have less impact on the portfolio’s overall performance.
While diversification is not a guarantee of higher returns, it can mean less downside in your portfolio when the market is down, and it can mean you will reap the rewards when the market goes up.
Here’s why: Imagine that the entire economy consists of just two companies, one that sells umbrellas and another that sells sunscreen. If you are invested only in the company that sells umbrellas, your portfolio will turn in a strong performance during Florida’s rainy season, but poor performance when the weather is sunny. If you are only invested in the sunscreen company, the portfolio will sizzle when the sun is out, but will drown when it rains. So, to minimize risk, your investments should be split between the two companies so that your portfolio will respond to changing weather conditions – sometimes up, sometimes down, but not swinging radically from sunny returns to drowning returns.
Here are a few tips to add diversity to your investment portfolio.
Take a look at where you’re invested now.
Figure out how much of your money is in cash, like certificates of deposit, money markets or other bank accounts. Review the stocks you own directly through a brokerage or online trading site. Take a look at the reports sent to you by mutual fund companies. If you work with a professional advisor, he or she will be able to tell you what companies you are invested in and the percentage of your portfolio that each of those companies represents.
Spread your portfolio among multiple investment types.
These include stocks, bonds and cash. Think about your life situation. Are you just starting out and trying to save to buy a home? Did you just have a child and want to save for college? Are you nearing retirement? With a diversified approach, you can allocate your money based on your short and long-term needs and the level of volatility you’re willing to accept.
Invest in different types of stocks.
Just “owning stock” is not enough. A portfolio should be diversified with investments in different types of stocks or mutual funds, including growth funds, balanced funds, index funds, small cap funds and large cap funds. Every mutual fund company categorizes their mutual funds by the types of companies they place investments in, and they give the names of the companies, too. This is important because in different economic and market conditions, different types of stocks perform differently. So, by diversifying your stock or mutual fund investments, losses in one area may be offset by gains in other areas.
Vary your securities by industry or geography.
This means that, for instance, you would not invest in only banking companies or only energy companies or only consumer goods companies. You might select a number of companies from those and other industries. It also means that you would not invest only in domestic companies, but would also incorporate some international companies into your investment plan. By choosing funds in many countries, political and economic events in any one country have less effect on your overall portfolio.
Keep in mind that while diversification reduces risk, it can also reduce returns. Historically speaking, 2008 was unusual, because so many different types of investments had a down year. Still, if you had a diversified portfolio, you would not have had all your money in the worst-performing investments. For instance, if you had bet on real estate or Latin American stocks, you’d have lost almost 60 percent over the past year, compared to losing “just” 39 percent if you were only invested in U.S. large cap companies.
However, since no one can know in advance exactly how any particular asset class is going to perform in any given year, it’s generally a good idea to spread your money around.
Diversification can’t ensure outstanding returns on your investments, but it can smooth out radical up and down swings and give you a good balance of risk and reward. Perhaps the most important benefit of diversification is the peace of mind that comes from knowing you have made a smart investment decision for you and your family.
Rob West is president and principal of Trust House, Inc., a fee-only financial and investment management firm. He is also a seminar instructor for Larry Burkett’s Crown Financial Ministries and co-hosts “All Things Financial” and “Vocal Point,” weekly interactive radio programs aired on 90.3FM WAFG. He is also the director of training for Kingdom Advisors. For information or to book a speaking engagement, call 954-351-2088. Please send questions and comments to [email protected]
The information in this article is for information purposes only and does not constitute advice. You should not rely on any information in this article to make (or refrain from making) any decision or take (or refrain from taking) any action.