One of the most important investing fundamentals is learning how to diversify your portfolio, a practice that reduces your risk and lowers your vulnerability.
What Is a Diversified Portfolio?
Portfolio diversification involves spreading your investments over a variety of assets and asset classes that minimizes one’s long-term risk. Rather than relying on a small group of concentrated investments, a diversified portfolio contains a variety of investments across the globe.
Different asset classes, such as stock, bonds, real estate, or sovereign debt, react differently to market moves and economic situations. The more diversified your assets, the more insulated you become against market downturns. More than anything, portfolio diversification protects investors against extremes. For this reason, diversified portfolios contain a mix of assets that have a reduction in correlation to each other.
For example, stocks and bonds tend to move in opposite directions from one another. Stocks are typically used for growth, as they appreciate faster than bonds, but are also subject increased volatility. Yet, having a wide variety of both asset classes ends up reducing the risk to an investor because it’s unlikely that every stock and bond you hold will fail all at the same time.
What History Tells Us About Diversification
The era spanning 2000 to 2010 is often referred to as “the lost decade” because of how much wealth was lost due to a slumping U.S. stock market. The S&P 500 Index, representing the nation’s 500 largest companies, underperformed at historically low levels, proving that even 500 companies may not be diversified enough.
If one were to invest one dollar in the S&P in the year 2000, that investment would have returned a mere $0.93 by 2010. However, a different story emerged for developing countries during the same period. While the U.S. was mired in two recessions throughout the decade, a group of smaller countries thrived. As a result, investments in emerging and developing countries went wild. If you were to invest that same dollar in global investments, you would more than double your investment, earning $2.06 per dollar.
Obviously, a recession or major financial event may cause you to rebalance your portfolio, but this may be the case even in the best of times. If your target significantly moves up or down, you may need to rebalance, since this often implies that you’re leaning too heavily on one group of assets or asset class.
Road to Diversified Portfolios
Like any financial strategy, portfolio diversification will differ depending on one’s financial and life situation. Regardless, a well-diversified portfolio contains as wide a range of investments as possible, with the minimal amount of fees and risks attached.
We like our clients to invest in a variety of holdings to lower their risk without giving up the chance to claim solid returns.
If you want to find the optimal way to diversify your portfolio, reduce risk, and maximize gains, it’s always best to talk with a trusted advisor likes the ones here at WWC.
Check Your Emotions Daily, Not Your Portfolio
Portfolio diversification is an active process requiring your attention and consistent upkeep. However, you shouldn’t glue yourself to your phone by checking your portfolio daily.
In fact, too much attention to one’s portfolio can produce worse results for an investor. Research by Richard Thaler on myopic loss aversion found that reviewing a portfolio quarterly instead of daily reduced moderate losses (of -2% or more) from 25% to 12%.
Why would checking one’s portfolio too much produce losses? The answer relies on stress and the emotionality tied to investment decisions. By monitoring every day, we tend to grow more emotional, thinking that every market move is impacting us more than it really does. It’s in our human nature to run when we see danger approaching and investing is no exception. However, selling during troubled times can often be the wrong move, especially when your goal is diversification. Remember: Choosing to take no action is still taking action.
Group Your Investments with Mutual Funds and ETFs
Buying individual stocks takes time and energy, especially if you want a properly diversified portfolio. A better option is going for low-cost mutual funds and exchange traded funds (ETF), which give you a basket of investments through a single purchase order.
Mutual funds contain a wide variety of investments bundled into a single fund and are priced once per day. Purchasing a mutual fund means having a proverbial school of fish rather than a fish or two, in the case of individual stocks. Since the mutual funds are so competitive, costs are pressured to stay low, benefitting investors.
ETFs are similar to mutual funds in that they contain a basket of investments but are traded like stocks. You can buy an ETF in nearly any industry, so it’s an easy tool to help you diversify your portfolio. Fees are also low, with some funds even being fee free.
Time and time again the data suggests that diversifying portfolios, focusing on long-term results and occasionally rebalancing is one of the best ways to achieve our financial goals.
This commentary was originally posted by Jennifer Means, CFP®, FPQP™- Mayl 10, 2022
Source: What Is a Diversified Portfolio? – TCI Wealth
**Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.