Diversify, diversify, diversify. Along with buy low, sell high, it's a core principle of long-term investing. It sounds super easy, but you'd be surprised how often people get diversification wrong.
In the world of investing, diversifying means spreading your money across different types of investments, including stocks, bonds, and cash, and within each type, too. You may wonder, why bother? Here are two really good reasons to diversify and three steps to get you on your way.
1. Minimize risk: Diversification isn’t about getting higher returns or preventing losses—it's about minimizing the impact of swings in the financial markets on your portfolio. Owning just one stock leaves you open to huge fluctuation in the value of your investment. To cushion your portfolio against the stock market’s inevitable ups and downs, consider owning many stocks plus some bonds and cash, which typically rise or hold steady when stocks fall. In investment speak, that’s called owning uncorrelated assets.
Sticking to your mix of assets—and spreading out your investments among different kinds of stocks, bonds, and short-term investments—may provide the potential to improve returns for your chosen level of risk. The more uncorrelated assets you own (either individually or through a fund), the less likely you are to be subject to the potential pain of one bad investment (or a few). There's no magic bullet, though: Diversification and asset allocation do not ensure a profit or guarantee against loss.
2. Stay disciplined: Many people who invest make emotional decisions when markets are either doing really well or really bad. Having an asset allocation plan you can live with, through good markets and bad ones, can help you resist those urges. That’s important. Studies show that investors often underperform the market because they let fear or greed get the better of them, jumping out of the market near the bottom and buying near the top. Successful investors have a plan and stay with it.
How to diversify
1. Mix it up: Building a diversified portfolio is a series of choices. The biggest, and arguably most effective in terms of risk and return, will be how you divide your money between stocks, bonds, and cash.
Stocks come with the most risk but have historically offered the opportunity for the highest reward. Bonds have generally been more stable than stocks, though you can still lose money buying and selling bonds or bond funds, and risk varies with credit quality and other factors. Cash, or short-term investments, are as close to risk free as possible.
Of course, your mix of stocks, bonds, and cash should be personalized, based on your goals, time frame, and temperament. Some people may feel uncomfortable with stock market volatility, so your emotional fortitude for seeing volatility in your account—your risk tolerance—is a variable you should consider. With a very long time until you need the money, your investments will probably have plenty of time to recover if there is a market downturn. For most young people, that could mean a fairly large helping of stocks in their retirement savings.
Now that you’ve diversified your portfolio broadly between stocks, bonds, and cash, there is still more diversifying to be done.
Stocks can be categorized by many characteristics—country, region, industry, sector, size, and attributes such as value or growth. To diversify, you may want a mix of U.S. and international stocks, as well as a mix of the stocks of large, medium, and small companies; different sectors and industries; and growth and value companies.
Bonds come in a variety of types, too. Some are issued by governments, others by corporations. They also vary by the credit quality of the issuing company and the length of time until maturity. You may benefit from having a mix of bond investments as well.
2. Review: Once you’ve diversified your portfolio, you can’t just walk away and forget about it. Over time, the value of your investments will likely shift, as well as your priorities. After all, life changes with marriage, children, promotions, moves, and more. To keep your investment and personal goals aligned, monitor your holdings at least annually. Checking in regularly can help you stay on track.
3. Rebalance: Let's say a rise in the stock market tips your portfolio too heavily toward stocks. That's great, because your stock investments have done well, but now you have more risk than you would prefer. So, you may want to rebalance by selling off some stocks, or by using new money, say from a bonus, to increase your bond investments or cash. Rebalancing ensures that your portfolio stays diversified according to your plan—and helps you with that other principle of long-term investing: Buy low and sell high.
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