By Gary Meeks, RICP®
We have all heard the phrase “don’t put all your eggs in one basket,” but what does that really mean? What does it mean to be diversified as it pertains to your money?
Investopedia defines diversification as “a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.”
I would like to discuss some ways investors can add diversification to their investment portfolios.
One important objective of diversification is reducing the risk of your investment portfolio without necessarily reducing the long-term returns. An essential strategy is to include investment assets into your portfolio that are negatively correlated, meaning they respond differently, often in opposing ways, to market influences. Historically, including both stocks and bonds in your portfolio has provided diversification and lowered risk to the portfolio because often stocks and bonds react differently under different economic and market conditions.
Example: In 2008 during the financial crisis, the S&P 500 stock index was down 36.6% while the Barclays Agg. Bond Index was up 5.2%. If at that time your portfolio had 60% invested in the S&P 500 stocks and 40% in the bonds included in the Barclays Agg. Bond index, your portfolio would have been down about 20% rather than 36.6% if you were 100% invested in the S&P 500 stocks. https://www.visualcapitalist.com/the-historical-returns-by-asset-class-over-the-last-decade/
Diversifying by Asset Type: In addition to stocks and bonds, other asset classes, such as commodities, real estate and cash/cash equivalents, can add diversification. It is important to be aware of each asset classes’ risk and correlation to the other asset types when building a diversified portfolio.
Other Methods: Investors can further diversify within the asset classes. For example, within stocks, including international, small, medium and large company stocks, can add diversification. As with stocks, there are a variety of bonds, including government, corporate and municipal. The other asset classes may provide further diversification within their own asset class as well. Most investors should consider using mutual funds or ETFs to accomplish this.
Individual stock investors may want to make sure they have stocks from different industries to add diversification to their portfolios.
Alternatives: Alternative investments include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment. Some alternative investments are unregulated and illiquid.
So, now that you know about all these great ways to diversify, where do you start? It is critical to determine your risk/return profile before making investment decisions. Some asset classes are riskier than others, so while it is important to diversify, it is also important to understand the risk/return characteristics of the different asset classes and sub classes.
Generally, stocks have higher risk/return profiles than bonds. The other assets have varying degrees of risk/return as well. It is critical to allocate according to your risk tolerance, time horizon and liquidity needs. If you’re doing this on your own, I would suggest spending a great deal of time educating yourself about the different asset classes, their risk and expected return characteristics. If this seems like a daunting task, consider seeing a qualified financial advisor to help you build a diversified investment portfolio.
Gary D. Meeks, RICP®, is a registered representative offering securities and advisory services through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker dealer and Registered Investment Adviser. Cetera is under separate ownership from any other named entity. 90 West 100 North STE 6, Price, UT 84501 (435) 637-8160.
A diversified investment portfolio does not assure a profit or protect against loss in a declining market. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
Investors can not invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. Past performance does not guarantee future results.
Investing in mutual funds is subject to risk and loss of principal. There is no assurance or certainty that any investment strategy will be successful in meeting it’ objectives.
Mutual funds and exchange-traded funds are sold only by prospectus. Please consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus contains this and other information about the investment company, can be obtained from your financial professional at (435) 637-8160. Be sure to read the prospectus carefully before deciding whether to invest.
The S&P 500 is an index of 505 stocks chosen for market size, liquidity and industry grouping (among other factors) designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
The Bloomberg Barclays US Aggregate Bond Index, which was originally called the Lehman Aggregate Bond Index, is a broad based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate debt securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency) debt securities that are rated at least Baa3 by Moody’s and BBB- by S&P. Taxable municipals, including Build America bonds and a small amount of foreign bonds
Source: https://www.investopedia.com/terms/a/alternative_investment.asp, https://www.investopedia.com/terms/d/diversification.asp,