- Investors often ignore risk when considering investments, focusing only on potential profits.
- Diversification is a powerful tool to reduce risk. It involves investing in companies that don't behave like each other.
- Easy ways to diversify is to invest in a basket of stocks, such as ETFs or mutual funds.
- While diversification reduces risk, it can also limit returns, be harder to manage, and incur more transaction fees.
The Hidden Half of the Coin
Have you ever had a friend or relative at a party yap about how they "made so much money in the markets"?
It doesn't feel like a big deal at first, but eventually, well, you start thinking, "I should make some money too!" But when you finally dip your feet in, things don't go the way you anticipate, and you lose money.
What went wrong?!
The unfortunate truth is that too many people focus on the potential returns of an investment 🤑, but don't consider the risk 😬. In technical terms, risk is the level of certainty (or lack thereof) that your actual returns match what you anticipate for any financial investment or decision. It is an invisible threat to every investment, and unfortunately, it can be hard to calculate and monitor.
But don't fret just yet, there are many ways to measure and reduce the risk. One of the most common ways to mitigate risk is to diversify your portfolio. That's what we're going to focus on today.
Tell Me About This "Diversification"
Diversification is a risk management tool that helps you achieve your goals even when the market has a few surprises. The idea is to mix your portfolio up with many different kinds of investments so that if any one of them takes a hit, the others still keep your net worth afloat.
This method considerably reduces the unsystematic risk (i.e., risks specific to any one company or one industry) from your portfolio.
Think of each security (e.g., stock) or industry as a basket, where you put your investments, aka “eggs.”
As the saying goes, you don't want all your eggs 🥚🐓 in one basket 🧺. A well-diversified investor has multiple baskets and all kinds of eggs!
Investors regularly review what their asset allocations look like, and then make the needed adjustments. We like to call the mixture of your stocks, bonds, and other investments an omelet 🍳, but other people know it as your asset allocation.
I know this seems like a lot, but keep reading, and we'll break this down even more.
Tips to Diversify Your Portfolio
Like all of investing, there is no "right answer" to diversification. But there are some general principles to follow. The goal is to pick investments that are a good fit for your needs, that you believe will do well, and that don't all have the same attributes.
A well-diversified portfolio should consider the following strategies:
- Stocks, Bonds, and more: Consider various types of securities for your investments. Each type comes with its risks and returns, so do your research. The most common types of investments are often in stocks and bonds. You can also consider commodities or real estate investment trusts (REITs), or just plain cash and short-term cash-equivalents (CCE).
- Large-, Mid-, Small-, or Micro-Cap Companies: An easy way to diversify is to invest in companies by their total valuation. Companies of different sizes have different growth and failure potentials. Mixing a few of them can help you get the benefit of the whole market.
- Domestic and Foreign Assets: Don't limit yourself to just your home! By investing in foreign securities, you expose yourself to many economies. This type of investment helps to remove unsystematic risk specific to any one nation. It allows you to benefit from overseas growth.
- Industries and Sectors: Make sure to look for companies in different industries and market sectors. Companies that work in different areas often grow and change differently from each other, which is perfect for a well-diversified portfolio.
- Asset Allocation or Target Date Funds: Asset allocation funds come with a predefined allocation (a mixture of stocks, bonds, cash, etc.). Target date funds take the asset allocation model even further; they can alter their risk profile over time automatically for you! They aim to adjust the risk profile of the fund to match what you might need at different stages of your life. Because these are pre-canned, make sure to scrutinize the funds and confirm that they are right for your risk profile and investment preferences.
- Mutual Funds, Index Funds, or Exchange Traded Funds (ETFs): Investing in securities that hold a basket of companies and sectors is an easy way to diversify your portfolio. These funds will naturally expose your money to many different assets. However, make sure to check that your funds aren't all just carrying the same companies! [object Object][object Object]Also, keep an eye out for their annual fees (i.e., expense ratio). Often you can find competing ETFs that charge differently; for example, as of July 2020, SPY charges 0.09%, while VOO charges 0.03%. Yet they both carry similar baskets of companies!
Diversification has its Drawbacks
Investing across a variety of securities will reduce your portfolio risk and volatility, but it does come with shortcomings.
- Owning a large number of assets is time-consuming to manage. Risk is a continually changing variable, and watching over many assets across portfolios is much harder than monitoring a few. Try not to overextend yourself by creating a portfolio that's not manageable. Keeping up with your investments is vital for long-term growth. [object Object][object Object]This is one of the reasons why ETFs have an expense ratio (annual cost). They do this automatically for you!
- Buying and selling often can incur more CFTs (commissions, fees, and taxes). Look for a broker that gives you commission-free or low-fee transactions. Reducing costs is one of the easiest ways to save some money.
- Diversifying your portfolio protects your downside, but it can also limit your upside. The idea is if some of your assets grow, then only some of your money grows. While this is rough, it's also true that if some of your assets lose value, only some of your money loses value. That's the whole point of diversification!
The Bottom Line
Diversification is a crucial component of creating a long-term portfolio strategy. It requires you to monitor your portfolio and re-balance your investments every so often. Even with the extra hustle needed, creating the right mix of investments will protect you and your returns in the long-term. Then you can be the cool person sharing your investment stories at the next party.
Disclaimer: This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. All investments involve risks, including possible loss of principal. There is no assurance that any investment strategy will be successful. Diversification does not ensure a profit or guarantee against a loss.