The Importance of Diversification
You’ve probably heard that old saying, “Don’t put all your eggs in one basket.” In other words, don’t put your money all in one investment, because if it fails, you’ll lose everything.
Diversification is an important part of long-term investing—think marathon, not sprint. Instead of chasing quick gains on single stocks, you’re taking a more balanced approach to building wealth.
How to invest and allocate may differ on a range of factors. You may adopt different strategies based on age, income, family responsibilities, lifestyle, financial resources, risk tolerance, and desires.
You are diversifying your portfolio by considering various asset classes: stocks, bonds, money markets, and real estate.
There are degrees of risks for all types of investments. The exception is when you keep all your money in savings accounts in the bank where they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person and per bank account. However, you will earn little to no money.
Risk and reward, sometimes referred to as your return, are positively correlated. The risk/return relationship means that higher returns come with greater risk, while low-return investments come with low risk.
If your time frame is short given your age or needs, you may want to opt for low-risk securities versus someone who can invest for a 20-30 year horizon. They can better absorb risk and volatility.
10 Tips For Diversifying Your Investment Portfolio:
- Asset Allocation
You should distribute your money among different assets based on your age and lifestyle. You can afford more risk in your portfolio at a younger age and be aggressive with more growth, such as stocks, than someone closer to retirement age. A good rule of thumb for allocation is to subtract your age from 100, and that would be the percentage of stocks in your portfolio.
For example, a 30-year-old could keep 70% in stocks (100-30) in the portfolio with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure and have 40% in stocks and 60% in bonds.
- Diversification Is A Must
Don’t put all of your eggs in one basket. Instead, you should be distributing your money among various classes of securities using an appropriate allocation. You should diversify within each security class. Investing in 10 energy stocks is not diverse. Branch out into multiple industries with different characteristics (e.g., high growth and strong dividend history).
- Growth Stocks
Stocks provide more growth, appreciating faster than other financial instruments over the longer term. However, the stock market can be volatile, as witnessed by the 57% decline during the Great Recession. It is a good idea to buy mutual funds or ETFs when you are first investing to achieve a diverse stock portfolio.
- Money Market Securities for Cash
Investors can easily convert money market securities into cash without loss of value. They are low risk/ low return instruments with liquidity, stability and provide access to money. The Treasury bills rated AAA are the closest to risk-free securities. They can be bought individually or as part of a MM mutual fund, including other short-term securities.
While these securities are known for safety, they do not provide much income. The Fed has battled the COVID-impacted recession in 2020. They reduced the fed funds rate to virtually zero and used aggressive measures. As a result, its needed actions have extended the low yield enviroment, challenging investors to find income from low-risk securities.
- Bonds With Different Characteristics
Investing in bonds is desirable for more predictable income streams. It is desirable to invest in various bonds: treasury bonds, municipal bonds, and corporate bonds. These all differ in terms of credit risk, liquidity, and tax benefits.
- Buy-Hold Strategy and Don’t Be Greedy
It is a prudent idea when building an investment portfolio to use a buy-hold strategy rather than trading securities. That said, don’t be afraid to pare down a holding that has appreciated too fast or begins to occupy a more significant proportion than you prefer. An old Wall Street saying is: “Bulls make money, bears make money, pigs get slaughtered.” I mean, don’t be greedy.
- Understand factors that impact the financial markets
You should know the role of interest rates, their connection to inflation, and how the Federal Reserve’s monetary policy can significantly impact the financial markets. To calm the markets, the Fed stepped in with substantial liquidity to combat the economic downturn caused by the pandemic in 2020. The Fed reduced already low-interest rates, making it hard to find income for savers and risk-averse investors.
- Have Some Exposure to Global Markets
Investors seek potentially higher returns and exposure to faster-growing global markets, especially when the US markets are experiencing weakness. The best way to do that is to find an ETF or mutual fund representing the exposure you want.
- Start Early To Benefit From Compound Interest
The earlier you begin to save and invest for retirement and investment accounts, the longer the time to take advantage of the power of compound interest. Start in your 20s. Find a compound interest calculator, plug in some numbers, using what you can set aside monthly for investing.
Use a reasonable return (don’t use 12%, which I have seen and find it challenging to achieve. Instead, try 7%) and provide the number of years you have until your retirement.
- Rebalance Your Portfolio Periodically
It is essential to periodically review your investment portfolio and consider rebalancing the various assets. Review it annually and make changes based on significant life milestones. Meeting with your financial advisor or accountant is an excellent way to review where your investments stand relative to you and your lifestyle.
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Article partially appeared on thecentsofmoney.com
Credit: thecentsofmoney.com, Forbes
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