When the market is booming, it seems almost impossible to sell a stock for any amount less than the price at which you bought it. However, since we can never be sure of what the market will do at any moment, we cannot forget the importance of a well-diversified portfolio in any market condition.
For establishing an investing strategy that tempers potential losses in a bear market, the investment community preaches the same thing the real estate market preaches for buying a house: "location, location, location." Simply put, you should never put all your eggs in one basket. This is the central thesis on which the concept of diversification relies.
Read on to find out why diversification is important for your portfolio and five tips to help you make smart choices.
Key Takeaways
- Investors are warned to diversify their portfolios, meaning that they should never put all their eggs (investments) in one basket (security or market).
- To achieve a diversified portfolio, look for asset classes with low or negative correlations so that if one moves down, the other tends to counteract it.
- ETFs and mutual funds are easy ways to select asset classes that will diversify your portfolio, but you must be aware of hidden costs and trading commissions.
What Is Diversification?
Diversification is a battle cry for many financial planners, fund managers, and individual investors alike. It is a management strategy that blends different investments in a single portfolio. The idea behind diversification is that a variety of investments will yield a higher return. It also suggests that investors will face lower risk by investing in different vehicles.
5 Ways To Help Diversify Your Portfolio
Diversification is not a new concept. With the luxury of hindsight, we can sit back and critique the gyrations and reactions of the markets as they began to stumble during the dotcom crash, the Great Recession, and again during the COVID-19 recession.
We should remember that investing is an art form, not a knee-jerk reaction, so the time to practice disciplined investing with a diversified portfolio is before diversification becomes a necessity. By the time an average investor "reacts" to the market, 80% of the damage is already done. Here, more than most places, a good offense is your best defense, and a well-diversified portfolio combined with an investment horizon over five years can weather most storms.
Here are five tips for helping you with diversification:
1. Spread the Wealth
Equities offer potential for high returns, but don't put all of your money in one stock or one sector. Consider creating your own virtual mutual fund by investing in a handful of companies you know, trust, and even use in your day-to-day life.
But stocks aren't just the only thing to consider. You can also invest in commodities, exchange-traded funds (ETFs), and real estate investment trusts (REITs). And don't just stick to your own home base. Think beyond it and go global. This way, you'll spread your risk around, which can lead to bigger rewards.
People will argue that investing in what you know will leave the average investor too heavily retail-oriented, but knowing a company, or using its goods and services, can be a healthy and wholesome approach to this sector.
Still, don't fall into the trap of going too far. Make sure you keep yourself to a portfolio that's manageable. There's no sense in investing in 100 different vehicles when you really don't have the time or resources to keep up. Try to limit yourself to about 20 to 30 different investments.
2. Consider Index or Bond Funds
You may want to consider adding index funds or fixed-income funds to the mix. Investing in securities that track various indexes makes a wonderful long-term diversification investment for your portfolio. By adding some fixed-income solutions, you are further hedging your portfolio against market volatility and uncertainty. These funds try to match the performance of broad indexes, so rather than investing in a specific sector, they try to reflect the bond market's value.
Index funds often come with low fees, which is another bonus. It means more money in your pocket. The management and operating costs are minimal because of what it takes to run these funds.
One potential drawback of index funds could be their passively managed nature. While hands-off investing is generally inexpensive, it can be suboptimal in inefficient markets. Active management can be beneficial in fixed-income markets, for example, especially during challenging economic periods.
3. Keep Building Your Portfolio
Add to your investments on a regular basis. If you have $10,000 to invest, use dollar-cost averaging. This approach is used to help smooth out the peaks and valleys created by market volatility. The idea behind this strategy is to cut down your investment risk by investing the same amount of money over a period of time.
With dollar-cost averaging, you invest money on a regular basis into a specified portfolio of securities. Using this strategy, you'll buy more shares when prices are low and fewer when prices are high.
4. Know When To Get Out
Buying and holding and dollar-cost averaging are sound strategies. But just because you have your investments on autopilot doesn't mean you should ignore the forces at work.
Stay current with your investments and stay abreast of any changes in overall market conditions. You'll want to know what is happening to the companies you invest in. By doing so, you'll also be able to tell when it's time to cut your losses, sell, and move on to your next investment.
5. Keep a Watchful Eye on Commissions
If you are not the trading type, understand what you are getting for the fees you are paying. Some firms charge a monthly fee, while others charge transactional fees. These can definitely add up and chip away at your bottom line.
Be aware of what you are paying and what you are getting for it. Remember, the cheapest choice is not always the best. Keep yourself updated on whether there are any changes to your fees.
Today, many online brokers have moved to $0 commission-free trading in many stocks and ETFs, making this point less of a concern. However, trading mutual funds, illiquid stocks, and alternative asset classes will still often come with a fee.
Why Should I Diversify?
Diversification helps investors not to "put all of their eggs in one basket." The idea is that if one stock, sector, or asset class slumps, others may rise. This is especially true if the securities or assets held are not closely correlated with one another. Mathematically, diversification reduces the portfolio's overall risk without sacrificing its expected return.
Are Index Funds Well-Diversified?
By definition, an index fund or ETF replicates some index. Depending on which index, it may be more diversified than others. For instance, the S&P 500 has over 500 stock components, while the Dow Jones Industrial Average has only 30, making it far less diversified. Even if you own an S&P 500 index fund, it is not necessarily a diversified portfolio. You should also include other low-correlation asset classes, including bonds, as well as modest allocations to commodities, real estate, and alternative investments, among others.
Can I Over-Diversify a Portfolio?
Yes. If adding a new investment to a portfolio increases its overall risk and lowers its expected return (without reducing the risk accordingly), it does not serve the goals of diversification. "Over-diversification" tends to happen when there are already an ideal number of securities in a portfolio or if you are adding closely correlated securities.
How Is Portfolio Risk Measured?
A diversified portfolio's risk is measured by its total standard deviation of returns. The larger the standard deviation, the greater its expected riskiness.
The Bottom Line
Investing can and should be fun. It can be educational, informative, and rewarding. By taking a disciplined approach and using diversification, buy-and-hold, and dollar-cost-averaging strategies, you may find investing rewarding even in the worst of times.
