You've done it! After doing your due diligence, you've opened your first investment account and started putting some of your hard-earned money into it each month. You know you're on the right track, but people keep talking about "diversifying" your portfolio, and you're mystified by what they mean. What's portfolio diversification, anyway, and why does it matter?
Why should you diversify your portfolio?
Simply put, you should diversify your portfolio so you don't have all your investment eggs in one basket. Diversification is a tactic investors use in order to spread risk around across a range of asset classes, financial instruments, industries and other categories. Diversification's primary goal isn't to maximize returns — rather, it's aimed at limiting volatility's impact on a portfolio.
Although diversification isn't a guaranteed hedge against loss, most investment professionals agree that diversification is the most important component of an investment strategy that achieves long-range financial goals while minimizing risk.
5 steps to diversifying your portfolio
1. Spread your money around into a range of components.
Rather than putting all your money into the stock market, you can start to diversify your portfolio by putting money into non-stock investments. Commodities, exchange-traded funds (ETFs) and real estate investment trusts (REITs) are only a few of the options you could consider. (Read on for more ideas.)
2. Keep adding money to your portfolio.
Related to the above, keep adding money to your investment portfolio on a regular basis. For those who receive regular paychecks from an employer, automatically rolling some portion of your paycheck into an employer-sponsored 401K or your own investment account could be a great way to automate your savings. If you work for yourself, you could implement the same strategy by setting up an automatic monthly deduction from your business bank account into your investment accounts or retirement funds.
Ultimately, the goal of regular investing should be to use dollar-cost averaging — a strategy that allows an investor to buy the same dollar amount of an investment on regular intervals regardless of the asset's price, thereby smoothing out the regular fluctuations caused by market volatility — to buy more shares when prices are low and fewer shares when prices are high.
3. Diversify within individual types of investments.
In addition to putting your money into a range of investment vehicles, you'll also want to diversify within vehicles. In the case of stocks, this means you don't want your entire stock holding to be a single stock — instead, you should look to buy different stocks across sectors in order to produce a stock portfolio with mixed-income, growth and market capitalization metrics. In the case of bonds, you should consider their differing credit qualities, durations and maturities.
4. Vary the risk profiles of your investments.
When you're diversifying your portfolio, you should be doing so with an eye to picking different investments with varying rates of return. This helps ensure that substantial gains in some investments can offset losses elsewhere in your portfolio.
5. Rebalance your portfolio on a regular basis.
Contrary to popular belief, diversification isn't a one-and-done activity. You should check your portfolio often and make changes when the risk level is no longer consistent with your financial goals, strategy or economic situation. Money Mozart founder Chris Muller recommends rebalancing your portfolio at least twice a year.
What components should be in your portfolio
1. Domestic stocks.
These are the bread and butter of most people's portfolios. They also generally provide the highest-growth opportunities over the long term. However, on the flip side, the high-growth opportunity comes with a hefty side of risk, especially in the short term. Because stocks are generally more volatile than other assets, a stock investment can be worth less if (and when) you decide to sell it.
These usually provide regular interest income and are considered less volatile than stocks. Because they usually behave differently from stocks, bonds can be a good counterweight to the stock market's unpredictability. Many investors who are focused on safety, versus growth, favor U.S. Treasury or similar high-quality bonds over stocks.
However, those investors will often have to accept lower long-term returns because many bonds — especially high-quality ones — don't offer returns as high as stocks over the long term. Two exceptions to this are high-yield bonds and some international bonds, which can offer much higher yields than high-quality bonds; however, these types of bonds carry higher risk.
3. Short-term investments.
This category includes money market funds (MMFs) and short-term certificates of deposit (CDs). Money market funds are conservative investments that offer stability and easy access to your money — they're ideal for those who are looking to preserve their principal. However, they usually offer lower returns than bond funds or individual bonds. CDs offer a slightly higher rate of return than MMFs in exchange for your agreement to keep your cash in the bank for a set period of time; if you take your money out before that time passes, you'll pay a penalty.
4. International stocks.
These have the same higher return and elevated risk as domestic stocks but are issued by non-U.S. companies. If you're looking for investments that offer higher potential returns, and are comfortable with more risk, international stocks could be a good addition to your portfolio. It's also worth considering that non-U.S. stocks often perform differently than their U.S. counterparts, so they can provide exposure to opportunities that aren't offered by U.S. securities and potentially respond to changing market conditions differently from domestic stocks (increasing your portfolio's ability to tolerate market changes).
Additional components to consider for your portfolio
1. Sector funds.
Sector funds are stock picks focused on a specific segment of the economy. These can be valuable for investors seeking opportunities in different phases of the economic cycle.
2. Commodity-focused funds.
Equity funds that focus on commodity-intensive industries, such as oil and gas, mining and natural resources, can be a good hedge against inflation. While only experienced investors should invest in commodities, these are a good choice for sophisticated investors.
3. Real estate funds.
Real estate funds, including real estate investment trusts (REITs), can help diversify your portfolio in real assets and provide some protection against inflation.
4. Asset allocation funds.
Asset allocation funds can be an effective single-fund strategy for investors who lack the time or expertise to build their own diversified portfolio. These funds can be managed toward a range of benchmarks, including: a specific completion date, a specific asset allocation, income generation and in anticipation of a specific outcome (such as inflation).
5. Index or bond funds.
Investing in securities that track various indexes can be a long-term diversification investment for your portfolio. Adding index funds or fixed-income funds to your portfolio can help further hedge against market volatility and uncertainty. These funds try to match broad indexes' performance, so rather than investing in a specific sector, they'll try to reflect the bond market's value.
Mistakes to avoid
1. Don't spread yourself too thin.
While it's better to own five versus one stock in the service of diversifying your portfolio, there comes a point beyond which owning additional stocks simply isn't necessary if your primary goal is to diversify your portfolio. The most conventional view is that an investor can achieve optimal diversification with only 15-20 stocks across a range of industries.
2. Don't allow fees to eat all your returns.
Because buying, selling and simply holding a range of investment vehicles can cause fees to add up, it's important to keep an eye on your fees to ensure that your investment fees don't eat up all your returns. Thus, a savvy investor will keep an eye on fees while they're working to diversify their assets. It's not necessarily the case that the cheapest option will always be the best; but by the same token, it's also important to ensure that you stay on top of your investment fees and understand what you're paying for.
3. Don't expect diversification to hedge against all risks.
There is always going to be an inherent risk in investing. No matter how smart you are as an investor, you can't fully eliminate this risk (if the financial crisis taught us anyway, it's that even the professionals don't always make the right calls when it comes to the market). Bearing this in mind, it's important to be realistic about what you expect a diversified portfolio to yield for you. It's realistic to expect reduced risk and more stable returns; it's not realistic to expect that your portfolio won't take some hits if the larger macroeconomic context changes significantly.
4. Don't invest everything.
Generally speaking, investment vehicles are less liquid than traditional banking accounts. So, even as you invest for your future, it's also important to keep a rainy day fund (three to six months is a good goal) on hand in a savings account to cover your expenses in case of a job loss, unexpected expenses or medical emergency.