By: Shawn Dye, Trust Officer
Diversification is holding investments which will react differently to the same market or economic event. For instance, when the economy is growing, stocks tend to outperform bonds. But when things slow down, bonds often hang on better than stocks. By holding both stocks and bonds, you reduce the chances of your portfolio taking a big hit when markets swing one way or the other.
The benefits of diversification include:
- Minimizes the risk of loss to your overall portfolio.
- Exposes you to more opportunities for return.
- Safeguards you against adverse market cycles.
- Reduces volatility.
One of the benefits of diversification in your investments is to minimize the risk of a bad event taking out your entire portfolio. When you keep a high percentage of your portfolio in a single type of investment, you risk losing it if that investment tanks.
When you’re invested in the winning team, however, diversification can feel like a punishment. It’s hard to keep money in a lagging – or worse: a declining – investment when your other investments are doing so much better. But it’s important to remember that today’s top-performer may become tomorrow’s fallen star.
Diversification is important regardless of your time horizon and goal. Any time you’re investing in the stock market, you should aim for a diversified portfolio.
As your goals or timeframe change so should your portfolio and the percentages across asset classes. Less risk means more in bonds and more risk means more in equities.
How to Diversify Your Portfolio
Contrary to sometime-popular belief, diversification is not a number’s game. He who owns the most investments doesn’t necessarily win the crown. The trick to diversifying your portfolio is owning investments that play different roles on your team.
Think about diversification as building a football team. A team of only quarterbacks – even if you had 100 of them – won’t do you much good in a game. To have a well-rounded team, you need lineman and a running back, wide receiver and a tight end. Likewise with your portfolio.
There are several ways to diversify your portfolio, but the same rule always applies: Each investment in your portfolio should serve a different function. For instance, for stock diversification you may have an S&P 500 index fund for exposure to U.S. large-cap stocks and another focused on small-cap stocks.
For optimal diversification of risk in a portfolio, consider alternative investments such as commodities. Alternatives don’t have a “high degree of correlation to traditional investments” like stocks and bonds.
When stocks and bonds are stuck moving up and down, alternatives can move diagonally. They’re a bit like taking the escalator instead of the elevator to your goals. With alternative investments in your portfolio, you’re less likely to get trapped between floors.
How to Tell if You’re Diversified
An easy way to determine if your portfolio is diversified is by looking at your current performance. Diversified investments won’t move in the same direction at the same time. If some of your investments are up while others are down, you’ve got diversification.