Investing experts and analysts scream diversify, diversify, diversify – but what is diversification? It’s the simplest way to boost your investment returns while reducing risk. Similar to asset allocation, it’s not placing all your eggs in one basket.
Technology makes it easy to diversify your investment accounts with a host of tools and apps. Examples include apps such as robo-advisors which automatically diversify your holdings to mitigate risk. Or, retirement accounts that offer target-date funds which provide a “set it and forget it” option that automatically diversifies and shifts your holdings as you get closer to retirement age.
What is diversification?
Diversification means owning a range of assets across a variety of industries, market capitalization and regions. As I discussed in my asset allocation article, diversification is the amount of your portfolio invested in various asset classes. Think of it like a pie chart.
Some of the most common types of assets that are included in investment portfolios include:
- Stocks are shares of companies and often, offer the highest long-term gains. However, are volatile due to economic conditions and company performance.
- Bonds are loans by corporations and government to fund projects. They provide income streams with modest returns due to their low risk.
- ETFs or index funds are comprised of many assets such as stocks, bonds and commodities that offers instant diversification.
Diversification is essential to any portfolio because it reduces risk while increasing potential returns. How? Not all assets perform the same – daily, weekly, or annually. Some of your assets this year will perform well, some so-so, and some not at all. Next year positions could reverse, with the former dawdlers becoming the new winners.
Don’t get to hung up on your winners and losers, a well-diversified portfolio tends to earn the market’s average long-term historic return — about 10% annually. Not too shabby. Just know in the short-term, returns vary greatly.
By owning a variety of assets, it minimizes the chances of any one asset hurting your portfolio. The trade-off is that it reduces your returns if a stock takes-off to the moon. Diversification is the turtle in the race against the hare; it’s slow and steady performance that reduces volatility putting your mind at ease.
» MORE: How to invest money
Diversification is an easy way to reduce risk in your portfolio, but it can’t eliminate it.
Investments have two broad types of risk:
- Asset-specific risks:These risks come from the investments or companies themselves. Asset risks include the success of the company, their performance and the stock’s price. Examples include their quarterly company reports, comprised of financial statements, such as balance sheets and income statements required by the SEC every three months.
- Market risks: The market is a roller coaster, affected by factors such as war, interest rates, weather and more. Just recently, the Iranian conflict saw oil prices surge. The markets are alive and constantly moving up or down.
You can reduce asset-specific risk by diversifying your investments but there is no way to eliminate it.
Imagine if you owned an all-bank portfolio during the global financial crisis? Yikes! Yet some investors did — and endured gastro-churning, insomnia-inducing results. The companies within a sector, such as banking, have similar risks, so a portfolio needs a broad variety of sectors. Remember, to reduce company-specific risk, portfolios have to vary by industry, size, and region.
How to diversify your portfolio
Diversification may sound difficult, especially if you don’t have the knowledge or time to research individual stocks, let alone learn how to do it. That’s why ETFs and index funds are so popular because they provide instant diversification — and have proven returns on performance.
I am a huge fan of M1 Finance, not only because they are free, but your portfolio is mimics a pie. Allowing you to instantly see how diversified your portfolio is. Here’s how diversification might look in your own portfolio using M1 Finance.
» GUIDE: Open an M1 Finance account
S&P 500 and Index Funds
One of the best options for passive investors is an ETF or index fund based on the S&P 500 index. Sectors, regions, and other indexes are commonly compared to the S&P 500 index because it’s a diversified stock index of America’s 500 largest companies – and one of the best historical performing indexes. Even though the companies are based in the U.S, they generate a huge portion of their sales overseas. Therefore, you’ll get the benefits of immediate diversification and exposure in just one fund.
So, you’re saying invest 100% in the S&P 500? No! As I mentioned, you can’t eliminate risk. Index funds such as the S&P 500 funds are heavily concentrated in stocks. To gain wider diversification, you may want to add bonds to your portfolio. Experts frequently recommend 80% stocks and 20% bonds for passive investing aka “set-it and forget-it” investing. Plenty of diversified bond ETFs exist, helping to balance out the volatility of a stock-heavy portfolio. Still, young investors with long time horizons — seven years or more — can see huge upside in owning an all-stock portfolio.
ETFs and index funds have exploded, most large investment companies offer some index and bond funds, and they’re readily available for individual retirement accounts and 401(k) plans. Usually, these funds have extremely low expense ratios, too.
» MORE: Retirement Accounts
Other options include target-date funds, which manage asset allocation and diversification for you. You set your retirement year, and the fund does the rest, typically shifting assets from high-risk, high-reward stocks to low-risk, low-reward bonds as you approach retirement. Know that these funds have higher expense ratios than basic ETFs because of the manager’s fees, but they offer value to investors who want to avoid managing a portfolio at all.
Wrapping it up
Again, don’t put all your eggs in one basket. Use readily available tools and applications to achieve diversification. Thus, mitigating risk and enhancing your ability to accumulate wealth short-term or long-term.
Diversify, diversify, diversify!