Diversification is key to building the best portfolio. What does this mean and why should you bother? You already have a variety of stocks including the Amazon stock that is so high, as well as your Apple and eBay stocks. And you are making a lot of money. What could go wrong?
You may be surprised by the next market downturn if your portfolio is filled with energy stocks and big tech stocks. When the market is highly valued, it’s easy to choose the “right” stocks. However, if the market is overvalued, it’s easy to pick the “right” stocks.
You need to have a diverse portfolio if you want to create wealth and make the right investments.
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What is diversification?
Investors should diversify their investments. Have you ever heard the expression “Don’t put your eggs in one basket”?
Diversifying your investments means that you can spread your money across multiple investment options, which lowers the risk of investing. Diversification is a way for investors to avoid huge losses that could result from putting all their eggs in the same basket.
Diversifying means that you don’t allocate all of your investment to the riskier stock market trading. Instead, you distribute it across various stocks and companies. To balance your portfolio, diversifying also means that you invest in safer investments like mutual funds or bonds.
Diversification means that you don’t rely on any one type of investment. The diversification strategy allows you to have a backup plan for your money in case one of your investments goes down.
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Why is diversification so important?
Diversification is a key factor in ensuring your money’s safety. That’s because:
It is easy to lose money investing with the sole goal of making immediate profits. The future can change at any moment. Stocks can plummet, markets crash, and fluctuations, as well as corrections, are all possible.
Diversifying the stocks that you invest in is not enough. It is important to diversify your investments, and not just in tech or energy stocks. However, you will need to make other investments to offset any market declines or corrections.
Diversifying your portfolio will help you balance market downturns. Diversifying your portfolio is like putting your faith in the fact that your investments will always work out as you expect. If you ask any experienced investor, this is not the best strategy.
Let’s suppose you believe tech stocks will be the future. You’ve had success with your tech stock investments so far. You take all your money and put it towards buying stocks for large-cap tech companies stocks.
Let’s assume that tech stocks are on a steady uphill climb, earning you a lot of money. Then, a few months later, bad news about tech sectors makes headlines. This causes cash-machine stocks in your portfolio to plummet, costing you tons of money. You have two options: sell your stocks at a loss, or hold them and hope they recover.
Let’s suppose you have a lot of large-cap tech stocks but also invested in small-cap stocks or medium-cap stocks. You could also invest in mutual funds. These other types of investments are consistent, but they have lower returns.
Your sure-thing tech stocks can take a tumble. You have safer investments that provide ongoing returns and help you to manage the risks associated with the more risky investments. Diversification is crucial. Diversification protects your capital while allowing you to make more risky investments in the hope of greater rewards.
Age determines the breakdown of diversification
While diversification is essential for all ages, there are instances when it’s better to be riskier with your investments. Money experts advise younger investors to invest heavily in riskier investments, and then to shift to more risky investments.
To determine the proportion of your portfolio you should keep in stock, subtract 100 from your age. This is because stock dips are less likely to happen as you approach retirement age.
You should hold 65% of your portfolio in stocks when you turn 45. Let’s see how it breaks down by decade.
Investors aged 20 years: 80% stocks, 20% “safer” investments such as mutual funds and bonds
30-year-old investor: 70% stocks, 30% “safer,” investments like bonds or mutual funds
Investors aged 40: 60% stocks, 40% “safer,” investments like bonds or mutual funds
50-year-old investor: 50% stocks, 50% “safer” investments like bonds or mutual funds
Investors aged 60 years: 40% stocks, 60% “safer,” investments like bonds or mutual funds
Investors aged 70 years: 30% stocks, 70% “safer,” investments like bonds or mutual funds
Diversification vs. Asset Allocation
Although diversification and asset allocation are often called the same thing, it’s not. Both strategies help investors avoid large losses in their portfolios and work the same way. However, there’s one major difference. Diversification is about investing in multiple ways with the same asset class. Asset allocation focuses more on investing across many asset classes to reduce risk.
Diversifying your portfolio means you invest in one asset class such as stocks. You then go deeper within that class with your investments. This could be investing in stocks with large-cap, mid-cap, small-cap, and international shares. It could also mean diversifying your investments across different types of stocks. But the main thing is that all of them are the same asset class: stocks.
Asset allocation means that you can invest your money in all asset classes or categories. You invest some money in stocks, while others are invested in cash and bonds. There are many asset classes. The most common ones include:
Alternative asset classes exist, such as:
Real estate, or REITs
The key to an asset allocation strategy is to select the right mix of high- and lower-risk asset classes and to allocate the correct percentage of funds to reduce risk and maximize the reward. As an example, a 30-year-old investor would advise that 70% of your investments should be in higher-risk investments, while 30% should be in safer investments. This will ensure that you are maximizing the risk/reward ratio.
You could also allocate 70% to a mix of riskier investments such as stocks, REITs, international stock, emerging markets, and other asset classes. To reduce the risk of losing your investment, 30% should be allocated to bonds or mutual funds.
Diversification is a way to diversify because certain asset classes perform differently depending upon how they react to market forces. Investors spread their assets across asset allocations to protect their money against downturns.
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A well-diversified portfolio includes components
It is important to have the right income-producing assets in your portfolio. This will ensure that you have a diverse portfolio. These are some examples of portfolio diversification:
Stocks are an essential part of a portfolio that is well-diversified. Stock ownership means that you are part of the company.
Stocks are riskier than other investments due to their volatility and rapid shrinkage. Your stock could drop in price and your investment may be worth less than what you paid. However, risk can pay. Stocks offer investors the chance to enjoy higher long-term growth, which is why they are so popular.
Stocks are one of the riskiest investments. However, there are safer options. You can choose mutual funds to be part of your strategy. If you have shares in mutual funds, it means that you are part of a company that purchases shares, bonds, and other securities. Mutual funds are safer than other types of investments because they reduce the risk involved in stock market investing.
You can also use bonds to diversify your portfolio. You lend money to buy bonds in return for interest over a set period. Because they have a fixed rate return, bonds are considered safer and more stable than other investments. They can also act as a cushion from the volatility of the stock markets.
However, the downside to this is that they offer lower returns and can be acquired over a longer time. There are other options available, such as high-yield bonds or international bonds that offer higher yields but come with greater risk.
Another component of a solid portfolio is cash. It includes liquid money, money in savings and checking accounts, certificates of deposit or CDs, and savings and Treasury bills. Although cash is the most volatile asset, you have to pay higher returns for it.
Diversification also includes additional components
Diversification can also include other components. These alternative assets, like the other asset types, can be used by investors to protect their portfolios. These assets include:
Real estate or REITs
Real estate funds (REITs) can be used to diversify your portfolio or protect against the risk of other investments. While real estate funds are similar to mutual funds in that they buy shares in stocks and bonds, you can also invest in companies that own, operate, or finance income-generating real property such as multi-unit apartments or rental homes.
Asset allocation funds
Asset allocation funds are funds that offer investors diversification across different asset classes. These funds are often the only fund that investors need to have a diverse portfolio.
International stocks are another option for investors to diversify their portfolios. These stocks are issued by non-U.S. corporations and can provide huge potential returns. However, they can also be very risky, just like any other investment with the potential to play a large return.
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Example #1 of a Diversified Portfolio: The Swensen Model
We want to share with you David Swensen’s diverse portfolio just for fun. David manages Yale’s famed endowment and has generated an amazing 16.3% annualized returns for over 20 years. While most managers can barely beat 8%, he is an extraordinary manager. He has doubled Yale’s wealth in the past four-and-a-half years, from 1985 to now. His portfolio is also above.
David is the Michael Jordan for asset allocation. He spends his time tweaking 1% here or 1% there. This is unnecessary. You don’t need to think about picking stocks. All you have to do is look at asset allocation and diversification.
His brilliant suggestion on how to allocate your money is:
ASSET CLASS % BREAKDOWN
Domestic Equities 30%
Real estate funds 20%
Government bonds 15%
Developed world international equities 15%
Treasury Inflation-Protected Securities 15%
Emerging-market equities 5%
What are your thoughts on this asset allocation?
A single choice is not sufficient to represent the entire portfolio.
Any sector can fall at any moment, as demonstrated by the tech bubble burst in 2001 and the 2008 housing bubble burst. You don’t want your entire portfolio to be affected by it. We all know that lower risk equals lower reward.
Asset allocation’s greatest benefit is the ability to reduce risk and still achieve solid returns. Swensen’s portfolio is an excellent example of a diversified portfolio.
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Diversified portfolio example #2: Ramit Sethi’s diversified portfolio example
Ramit Sethi, our founder, and financial expert has created this investment portfolio.
This is how the asset classes are broken down:
ASSET CLASS % BREAKDOWN
These are three context pieces that will help you understand the WHY behind numbers.
Lifecycle funds: The foundation of my portfolio
Ramit suggests that most investments be in lifecycle funds, also known as target-date funds.
Asset allocation is everything. Ramit chooses target-date funds to automatically rebalance his portfolio. This is a simple decision for anyone who:
Do you not want to have to constantly rebalance your portfolio?
These funds diversify your investments based on your age. Target-date funds adjust automatically for your asset allocation as you age.
Let’s take an example:
Vanguard Target Retirement 2050 Fund, (VFIFX) is a fund that can help you retire in 30 years. 2050 is the year you are most likely to retire.
This fund will still contain stocks and other risky investments, as 2050 is still far away. As you get closer to 2050, however, the fund will automatically adjust so that it contains safer investments like bonds.
These funds may not be right for everyone. There may be different goals or levels of risk for you. You may choose to invest in individual index funds outside your retirement account for tax benefits.
They are not for those who want to rebalance their portfolios. Lifecycle funds may be more convenient than the potential loss in returns for you.
It’s not a good idea to have all your eggs in the same basket as an investor. It’s important to choose the right strategy.
Both types of investment strategies can reduce risk and increase the potential for rewards. That’s what investing is all about. You will reap the rewards of a well-diversified portfolio if you do your research.