Why and How You Diversify an Investment Portfolio
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For decades, experts have warned Americans not to rely on Social Security as a viable way to support themselves during retirement.
The Federal Government implemented Social Security in 1935 to provide Americans with some income to supplement their finances after retirement. But Social Security was never intended to be a total solution.
The best option Americans have to ensure they can maintain a decent lifestyle in their twilight years is to save money and grow a diversified investment portfolio.
Read on to learn more about why it's important to choose different types of investments to gain positive returns, and how to diversify your investment portfolio.
Getting Started With Investing
Tracking expenses and using a budget will help you take control of your finances.
To avoid taking on debt, create sinking funds for anticipated expenses, and build an emergency fund for unexpected events.
“Invest early and often” is a saying you might hear about building wealth and financial stability to last a lifetime.
The power of compound interest is set in motion once you start saving and begin to invest even a small portion of your salary.
If you aren’t sure how or where to invest your money, you’re not alone. But you can start your investing journey by learning some basic terms and information.
Then you can work with a financial advisor, use a robo-advisor, or even DIY your investing.
Your financial health and individual goals should drive the investing decisions you make.
Taking some financial risk is essential, but you may want to steer clear of putting all of your ‘investment eggs’ into one basket.
Financial professionals will tell you, diversification is the best way for any investor to get the results they want (and still sleep well at night!)
What Does Investment Diversification Mean?
As you consider investing your money, it’s important to understand there may be limitations on how much money you can save.
Thus, you'll want to consider how to balance your desire to increase your wealth, with your need to protect your financial future.
The best way to achieve that end is to build an investment portfolio with various investments.
Diversification is the process of investing in a variety of investment vehicles, as opposed to putting all of your money in just one type of investment option.
For all intents and purposes, the field of potential investment options (asset classes) include:
A well-diversified investment portfolio would typically include at least a few of these asset class options.
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The Goal of Diversifying Your Portfolio
Over time, every type of investment will experience ups and downs. Even cash investments, which typically aren't at risk of loss, will provide higher and lower returns over an extended period.
How do you protect yourself from investments that may struggle at times in the future?
The goal of a well-diversified investment portfolio is to provide steady returns consistently, even if one investment option falls on bad times.
When an investment portfolio is well-diversified, it will contain investment vehicles that tend to complement one another.
Example: Bonds rates tend to go up when the stock market corrects, and stock values fall – a diversified portfolio that includes bonds will manage to survive a stock market storm in the short-term better than a non-diversified portfolio would.
Additionally, it’s important to diversify within investment types.
In other words, you don’t want to invest in only tech stocks, or small-cap stocks, or short-term treasury bonds. But in a variety of stocks and bonds, which can be classified by size, location, sector, or style.
Bottom-line, diversification can help take some of the volatility out of your returns.
The Risk-Return Tradeoff
It takes a little work to diversify an investment portfolio. To begin with, each investor has to make decisions about their investment goals and how they feel about risk.
It's crucial to understand there’s always going to be a correlation between the level of potential returns someone can expect and the risks they are willing to take to get those returns.
Creating an investment policy statement will help you define your long-term financial goals and determine your savings rate, risk tolerance, desired investment options and allocations, and timeline.
As a general rule of thumb, younger investors should take more risks. That might mean exposing themselves to potential losses in hopes of getting higher returns.
Young investors may look to own a more significant proportion of smaller, more aggressive stocks. But they shouldn't exclude well-established blue-chip stocks – that'd just be another way to be undiversified.
There have been many times in the stock market that risk has NOT been rewarded with better returns. Younger investors might choose to leave out the bonds, however.
An example portfolio for a young investor might be 25% large-cap stocks, 25% mid-cap, 25% small-cap, 15% international, and 10% REITs or real estate holdings.
On the other hand, older investors might want to take a more conservative approach to investing as they draw near retirement.
The simple truth is, more mature investors have less time to recover from losses than younger investors do. Thus, older investors may want to reduce the percentage of stocks they own and include bonds instead.
Also, if investors are buying individual securities, it's important they diversify by the industry too.
It's very common to see doctors with portfolios full of pharma and medical device stocks. And petroleum engineers with all oil and oilfield service companies in their portfolios. That isn't diversified either!
Beware of too much company stock as well. It’s easy to do, especially if your employer makes matches in company stock.
But if a business experiences hard times, their stock may decline at precisely the same time as they’re laying off employees – not a good time to have all of your money in company stock.
Ultimately, the best way to diversify your investment portfolio is to align your investment decisions with your financial goals. By taking that approach, you are far more likely to succeed.
How to Diversify Your Investments
When you’re preparing to invest, you’ll identify which investments you favor. It’s also a good idea to consider consulting with a fee-only financial professional or coach.
To give you a better idea of what investors usually expect in the way of returns from each of the investment vehicles mentioned above, here are some general guidelines you can consider:
- Stocks – 7% to 10% annually over the long-term
- Bonds – 2% to 5% annually with no to low risk
- Real Estate – 6% to 20% or more depending on the type (commercial, single-family rentals, REIT’s, etc.)
- Precious metals – 2% to 5% often held as a hedge against inflation
- Cash – 1% to 2% annually with no risk
Note: Each option provides access to products that offer higher returns with a higher risk. What you decide becomes a matter of personal risk preference, as stated above.
Establishing Your Portfolio
Let’s say you accept the idea you want to use the five investment options we’ve listed. So now, you’ll form an “investment basket” for each asset type.
Then, allocate a percentage of your investment portfolio you want it to contain. This holds if you’re using your employer-sponsored 401(k) account as your investment portfolio, or a brokerage account.
Example asset allocation:
- Stocks – 80% (large-cap, mid-cap, small-cap, and international stocks)
- Bonds – 5% (treasury, municipal or corporate bonds)
- Real Estate – 5% (REIT's, real estate investment trusts – or investment properties)
- Precious metals – 5% (such as gold or silver)
- Cash – 5% (certificates of deposit, money market, etc.)
After establishing your investment baskets and the weighted percentage you want going into each one, it's easy to start allocating your savings and future investment contributions.
Once you’ve developed an investment strategy, you need to monitor the progress of each option. Should one or more options seem to be underperforming regularly, you need to be ready and willing to make portfolio adjustments.
As an example of making a change, you might alter your stock portfolio by switching up the stocks you are invested in. Or choosing to lower (or increase) the percentage of your portfolio you’re allocating to stocks.
You might also sell a real estate investment property. Or double-down and purchase a multi-family unit or commercial office building.
At all times, you still want to maintain some level of portfolio diversification amongst your investments.
Rebalancing is mentally hard.
Investors tend to dislike selling poorly performing stocks.
The problem is that if you continue to hold on to the slow growers (“it'll go up soon, I just know it”) and sell the ones that are performing well, you'll have a portfolio full of junk!
You also have to prune some really good performers. Anyone who bought a 15% portfolio position of Microsoft 10 years ago might find that it's now 50% of their portfolio weight.
Rebalancing when the market’s down, means selling investment assets that have held their value well (often bonds) and buying more of the worst-performing investments in the portfolio.
Rebalancing when the market is high, means selling stellar performers and buying more of the ones that currently look like duds. For this reason, if you have an automatic rebalance feature on your account (common in 401(k)’s), use it!
Final Thoughts on the Importance of Investment Diversification
When you start investing, you'll make mistakes. If you become a student of the investment process, you'll learn from your mistakes and eventually find your way to creating a pretty well-balanced and diversified portfolio—another step towards building a solid financial house.
Next: Protect Your Retirement Savings from Inflation
Article written by Amy Blacklock and Vicki Cook, co-founders of Women Who Money, with contributions and review by She’s FIRE’d.