On a similar note...
On a similar note...
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Diversification is the simplest way to boost your investment returns while reducing risk. It may sound like an impossible investing goal, like juggling flaming pitchforks, but a diversified portfolio can actually be easy — and critical — for new and passive investors to achieve.
There are a variety of tools at your disposal that help make it easy to diversify your investment accounts. Read on to learn more about what diversification is, why it's important and how to put it into action.
What is diversification?
Diversification is the act of spreading investment dollars across a range of assets to reduce investment risk. It's part of what’s called asset allocation, meaning how much of a portfolio is invested in various asset classes, or groups of similar investments.
Investors have many investment options, each with its own advantages and disadvantages, responding differently across the economic cycle. Some of the most common ways to diversify your portfolio include diversification by asset class, within asset classes and beyond asset class.
Diversification by asset class
The three main asset classes within an investment portfolio are stocks, bonds and cash.
Stocks offer the highest long-term gains but are volatile, especially in a cooling economy.
Bonds are income generators with modest returns but are usually weaker during an expanding economy. Generally, bonds have an inverse relationship with stocks.
Cash (or cash equivalents) provide the least risk and thus the lowest return. Cash can buffer volatility or unexpected expenses and acts as “dry gunpowder” to invest during opportune times.
There are other asset classes such as real estate, commodities and alternative investments. These asset classes usually have lower correlation to the stock market and as such can be effective to aid in diversification.
Diversification within asset classes
After asset level diversification, investors can further the process by paying attention to details within each asset class.
Industry or sector. Intermingle companies operating in all kinds of industries because the economic cycle affects each business and respective stock differently. Some sectors are considered cyclical, where a company’s fortune moves in sync with the economic cycle. Examples include consumer discretionary (clothing, electronics, cars, etc.), financial services, basic materials and real estate where demand grows as the economy gets stronger. Some sectors are considered defensive, where the company’s business is less impacted by the economic cycle. Examples include consumer staples (groceries, tobacco, etc.), utilities and healthcare; necessities consumed at all times.
Size or market capitalization. Mix large-cap, mid-cap and small-cap companies (big, medium-size and small companies). Larger companies tend to be more stable and can weather economic downturns more easily but they also tend to have less growth potential vs. their smaller counterparts.
Style. Couple growth and value-oriented stocks. Growth stocks are characterized by rapidly growing sales and profits. Value stocks are companies whose stocks are “on sale” or seem underpriced or undervalued.
» MORE: How to buy stocks
Type of issuer. Integrate bonds from various issuers such as Treasuries (U.S. government bonds), municipal bonds, corporates and more.
Credit quality. Combine bonds with varied credit risk. Bonds offer different levels of creditworthiness or safety, which corresponds with the bond’s level of return. For instance, Treasuries are considered practically risk-free since it’s unlikely the federal government will go bankrupt, which explains their relatively lower rate of return.
Maturity. Blend short-, intermediate- and long-term bonds. Longer-term bonds receive higher returns because they are subject to more interest rate risk.
» MORE: How to buy bonds
For both stocks and bonds
Geography. Incorporate stocks and bonds from around the world. Countries have varied economic cycles so it makes sense to have exposure to both domestic and international markets. International markets are further classified as developed markets and emerging markets. Developed markets (European nations, Australia, Japan, Singapore, etc.) tend to have more stability whereas emerging markets (Brazil, Russia, India, China, etc.) have more growth.
Active vs. passive. Allocate to both actively and passively managed funds. Many securities can be purchased through mutual funds, index funds or exchange-traded funds (ETFs). In active funds, a portfolio manager picks which stocks to include in the fund. This differs from passive index funds or ETFs, which mimic an underlying index and cost less. Passive funds often can outperform active funds during market upswings but active funds can have better downside protection during market downturns.
Diversification beyond asset class
Diversification can extend beyond traditional asset classes found in typical investment accounts. Investment accounts have non-guaranteed returns since they are subject to market fluctuation. However, there are other product types such as pensions, annuities and insurance products that can provide guaranteed income streams and returns. Often, investors diversify their portfolio by spreading their investment dollars amongst these different product types as well.
Why is diversification important?
Diversification provides what professionals call a “free lunch” — reducing overall risk while increasing the potential for overall return. That’s because some assets will perform well while others do poorly. But next year their positions could be reversed, with the former laggards becoming the new winners. Regardless of which stocks are the winners, a well-diversified stock portfolio tends to earn the market’s average long-term historic return. However, over shorter time periods, that return can vary widely.
Below, the graphic from J.P. Morgan shows the variability of different types of investments from 2004 to 2018. Navigating the market’s fickle nature, the “asset allocation portfolio” (a diversified portfolio with a mix of investments) stays in the middle of the pack, achieving an annualized return of 6.2% over the time period and evening out the ride.
Owning a variety of assets minimizes the chances of any one asset hurting your portfolio. The trade-off is that that you never fully capture the startling gains of a shooting star. The net effect of diversification is slow and steady performance and smoother returns, never moving up or down too quickly. That reduced volatility puts many investors at ease.
The fine print on diversification
While diversification is an easy way to reduce risk in your portfolio, it can’t eliminate it. Investments have two broad types of risk:
Market risk (systematic risk): These risks come with owning any asset — yes, even cash. The market may become less valuable for all assets, due to investors’ preferences, a change in interest rates or some other factor such as war or weather.
Asset-specific risks (unsystematic risk): These risks come from the investments or companies themselves. Such risks include the success of a company’s products, the management’s performance and the stock’s price.
You can radically reduce asset-specific risk by diversifying your investments. However, do what you might, there’s just no way to get rid of market risk via diversification. It’s a fact of life.
You won’t get the benefits of diversification by stuffing your portfolio full of companies in one industry or market. How terrible would it have been to own an all-bank portfolio during the global financial crisis? Yet some investors did — and endured stomach-churning, insomnia-inducing results. The companies within an industry have similar risks, so a portfolio needs a broad swath of industries. Remember, to reduce company-specific risk, portfolios have to vary by industry, size and geography.
How to build a diversified portfolio
Diversification may sound difficult, especially if you don’t have the time, skill or desire to research individual stocks or investigate whether a company’s bonds are worth owning. Most securities can be purchased individually or in a collection, such as through a mutual fund, index fund or exchange-traded fund (ETF). For example, simple, low-cost, "set it and forget it" ETFs or mutual funds — especially index funds and target-date funds — and other options such as robo-advisors can get a portfolio diversified quickly and safely while reducing risk.
Here's how diversification might look in your own portfolio.
A commonly used option for passive investors is an ETF or mutual fund based on the S&P 500 index, a broadly diversified stock index of 500 large, industry-leading American companies. It’s diversified by industry and even though the companies are based in the U.S., a significant portion of their sales is generated overseas. Buying the S&P 500 is an example of how you can gain benefits of immediate diversification with just one fund.
The downside: Such funds are concentrated in stocks. To gain wider diversification, you may want to add bonds to your portfolio. Plenty of diversified bond ETFs exist, and they could help balance out the volatility of a stock-heavy portfolio.
Virtually all large investment companies offer some index and bond funds, and they’re readily available for individual retirement accounts and 401(k) plans.
» MORE: How to invest your IRA
Other options include target-date funds, which manage asset allocation and diversification for you. You set your retirement year, and the fund manager does the rest, typically shifting assets from more volatile stocks to less volatile bonds as you approach retirement. These funds tend to be more expensive than basic ETFs because of the manager’s fees, but they can offer value for investors who really want to avoid managing a portfolio at all.
With these options, you can achieve the benefits of diversification relatively simply and affordably.
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