When you hear the term ‘portfolio diversification’ with regard to your investments, you might believe you’ve got a clear concept of it: don’t put all your eggs in one basket. Sounds simple enough.
But there are many categories and degrees of risk that each of your ‘eggs’ can encompass. This makes this simple concept much more complex. While you correctly understand that portfolio diversification is not having all of your funds allocated to a single type of investment, there’s far more detail to delve into.
Why diversify?
Think of it like baking a cake. To make a great cake, a cake with the perfect texture and flavor that rises as it should, you’ll need different ingredients, each with their own performance in the cake baking process. Vanilla adds flavor. Baking powder allows the cake to rise and hold its shape when working with the eggs, and so on.
Leave out an ingredient, or don’t add enough of it, and you will wind up with a gloppy, inedible mess that doesn’t stand up to what it could have been. Each ingredient must be finely measured to perform in the right combination of other ingredients.
The same goes for your portfolio. The ‘cake’ you’re making with your allocations of stocks, bonds, real estate and other classes of investments, will be uniquely yours. That blend works together for, ideally, the best outcome for you.
Being diversified with your investments is very important. Different sectors of the market may be performing in different ways depending on what’s going on in the world. For instance, large cap funds may be on the upswing, while small cap funds may be headed into a bit of a slump. If you’re properly diversified, you’ll see your large caps gain. Then breathe a sigh of relief that all of your eggs aren’t in that small cap basket for what could be a very distressing couple of weeks, months or even years.
Risk Tolerance
Your tolerance for risk will help design your diversification plan. If you favor higher risk, with hopes for higher gains, you may have more stocks in your portfolio. If you favor a more conservative approach, you may wish to carry more on the bond side.
Risk is just one of the factors that will help you and your financial planner chart a diversified course for your investments. Another is time, how many years your portfolio will be performing with you. The next layer of this complex ‘recipe’ is categories of investments that interest you:
- U.S. and international stocks
- Short and long-term bonds
- CDs
- Fixed and indexed annuities
- As well as many others.
While this list might cause your heart to pound a bit, with so many types of funds to consider, the good news is that there are so many types of mutual funds and exchange traded funds (ETFs) to consider. You have plenty of opportunities to diversify. And quite importantly, you’ll have a knowledgeable financial planner on your team. Your financial planner can help you understand and select the various types of investments that could create more of a winning combination for your portfolio.
Don’t try to predict the market
Not too many years ago, we all saw what happens when diversification isn’t put into practice. During the days when digital stocks were flying high, investors in that one sector enjoyed tremendous profits. They likely parked all of their money where they assumed it would just grow and grow and grow.
But the clouds formed, and those not diversified at the time, held on to their stocks for too long, suffering great losses when that sector slid down. And by great losses, we mean the loss of stock value and – in many cases – the loss of a job when the company’s downward turn signaled, too late, that the company or field was in trouble. Consider that time in our country’s financial history to be a clarion call for diversification. Smart diversification, led by an experienced financial guide.
Now let’s talk what you might do when stocks and bonds are on a downward trend. Sometimes when stocks and bonds domestically and around the globe go down, that’s when precious metals may up. So it can be a wise move, considering that possible action on the market, to add some precious metals to your portfolio. Your financial planner can share more scenarios like this one, even though the market can never be known as a perfect science. Still, if your financial advisor can share a multi-pronged market interaction with you, it’s best to listen and learn.
Again, diversification is configured by your own tolerance for risk and the time you have for your portfolio to perform.
What is portfolio re-balancing?
Now let’s depart from the cake analogy. Once you bake it, it’s done. You can’t go back and reconfigure the ingredients to create a better, more fulfilling cake.
This is not so with your portfolio. You absolutely can and should re-balance your investments to better fit your current tolerance for risk and the current amount of time for your portfolio to perform.
When should you do this? How many years in is the perfect time to re-diversify your portfolio? There’s no one answer to this. For each person, timing is unique, as your life situation may change, your comfort level with the market increases or decreases, and so on.
Your financial advisor will be a great source of input here, discussing with you the ins and outs of changing your percentages as best fits your situation.
With your portfolio well-diversified, you will likely to better weather those inevitable storms on the market, global shifts in values, domestic company news and performance reports, even political actions that swing the market. Knowing your eggs are in many different baskets, and the eggs themselves are well-chosen, you achieve a greater level of peace, and ideally profitable advantages with your portfolio.
Is your portfolio diversified?
So ask yourself this: am I diversified? If your answer is:
- A shrug and an “I hope so,”
- It was when you created it 10 years ago
- You created your own portfolio last week
Feel free to call us for a second opinion.
Diversifying doesn’t have to be messy or mentally taxing. It’s one of the best things you can learn more about right now to clear up any misconceptions you may have and to help you build a portfolio that, years from now, you can be proud you took the time to blend, measure and make.
For more information on diversifying, and for our discussion about choosing between small cap funds and large caps funds (if you even should!), listen to our podcast.
