Diversification is Not Just Choosing a Bunch of Different Stocks
We’ve all heard the same advice again and again – an investor’s portfolio should be diversified and mixed so that if something goes down in one area of the market, you don't lose your shirt with every egg in one basket. The problem, however, is that the idea of diversification is not always well-explained or understood. So instead of really diversifying, some investors just create a portfolio of stocks. They believe they are diversified with stocks in a food company, a tech business, an oil company and a pharmaceutical, but in reality all of their investment is still in one location: a public stock market.
What is 'Diversification?'
True diversification is a risk management technique that mixes a wide variety of investment types within a portfolio. You combine different investment types together so they are truly offsetting each other with the primary goal of both protecting value and growing worth. That may mean utilizing all possible areas of investment that are viable for the investor. These may include, but are not limited to, cash, certificate of deposits, real estate, bonds, government savings, and more. When these areas are combined with investment in stocks, then an investor is really starting to exercise diversified protection.
Most regular investors have a limited budget for investing and may find it difficult to create an adequately diversified portfolio. This fact alone is one of the major reasons mutual funds have seen such a sharp increase in popularity. Buying shares in low cost, passive, index mutual funds can provide investors with an inexpensive source of diversification.
A Lesson in the Importance of Diversification
During the mid 2000s, the big boom was stocks and real estate. But as the bubble burst at the end of the decade, investors who had most of their money locked up in one or the other lost two-thirds of their investment when the bottom fell out from under the market. Even the most diversified investor still took a loss, but those who had truly worked to diversify their portfolio took less of a loss. Those closest to retirement age who hadn't diversified their portfolio were hit the hardest, as they didn't have the luxury of waiting years for the market to bounce back.
We are seeing history repeat itself today. At the beginning of the 2018, the Stock Market was at an all time high and everyday was a new record for the Dow. This surge was driven largely by high corporate earnings especially in the High Tech Sector. There was also very little volatility - prices kept going up but not down. The seemingly low risk investment environment and fear of missing out overheated the market and gave investors a false sense of security. There was a feeling that earnings growth was guaranteed. Why invest in low yield bonds when you could get higher (and almost guaranteed) returns with stocks? Which is what some investors thought.
Investors who were heavily invested in stocks and not properly diversified, received their wake up call yesterday, February 5th. The Dow Jones lost almost 1,200 points which is the worst point decline in history. The stock market declined sharply for a number of reasons but emotions played a big part in the sudden drop.
How do everyday investors protect themselves from these events? Through Diversification. Again, diversifying a portfolio is not about getting a bunch of different shades of the same investment type. It is really about mixing different investment types that are entirely unrelated to each other in how value is generated. A good offense is your best defense and in general, a well-diversified portfolio can weather most storms. Of course, your diversification strategy should also change with time as you get closer and closer to retirement. Working with a financial advisor who understands your goals, risk tolerance, and retirement plans can be crucial to helping you create a portfolio that is truly diversified.
The information in this material is not intended as investment, tax, or legal advice. The opinions expressed and material provided are for general information only.