We’ve all heard the warnings about “putting all your eggs in one basket.” When it comes to diversifying your investments, that adage is not only relevant — it could mean the difference between financial success and failure.
Investment diversification involves choosing a wide array of investments to help protect your portfolio from the effects of any one market trend, event or setback. Many financial professionals believe that choosing different investments from the common asset classes (such as stocks, bonds, and cash-related investments) can benefit a portfolio, since most asset classes generally do not experience the same type of performance simultaneously. (For example, when stocks are performing well, bonds may be in a downturn.) While diversification is no guarantee against investment loss, well-diversified investors often survive a downturn in the markets better than those who are not diversified.
Which Risks Can Be Diversified?
Diversification works to reduce some risks, but not all. For example, you could own a Standard & Poor’s 500® Index mutual fund that is well diversified (since it holds the 500 large-company U.S. stocks that make up the S&P 500 Index). By definition, the S&P 500 Index is well diversified in regard to “stock-specific” and “industry-specific” risks. Yet, if you were to hold an S&P 500 Index fund during a prolonged stock market downturn, you could lose a substantial portion of what you’d invested in that fund.
The truth is, holding 500 large-company stocks still exposes you to the “systematic risk” of the U.S. stock market. So regardless of how many different stocks or stock mutual funds you hold, you can’t reduce the risk of investing in stocks when stocks are losing their value.
The Value of Asset Allocation
The best way to reduce the “systematic risk” of stocks (or any other asset class) is to spread your money among several classes – such as stocks, bonds, and cash-related investments (like certificates of deposit and money market funds). This can be accomplished through a disciplined program of asset allocation, which sets guidelines for each asset class based on the individual investor’s objectives and risk tolerance. The next step is to diversify effectively within each asset class:
- For the portion of your money committed to stocks, a few carefully selected equity mutual funds can help you diversify among a variety of industries and company sizes
- For the portion of your money committed to bonds, you can diversify among short-term and long-term maturities and also among high-quality issues and those of lower quality that offer potentially higher yields.
- Cash-related investments play a special role in asset allocation. Since they tend to produce more stable (although very low) investment performance than either stocks or bonds, cash-related investments are useful for adjusting overall risk. Even in a terrible year for stocks or bonds (or both), a portfolio diversified partly in cash can suffer less investment loss, since cash-related investments may help to protect the investor’s principal, whereas stocks and bonds do not.
Important Questions to Ask Yourself
Here are some basic questions to ask yourself when choosing investments:
- What is my risk tolerance? A financial professional can help you answer this question by helping you understand your investment goals, how long you’ll invest your money, and how you feel about investing.
- How well diversified is my current portfolio? A financial professional can evaluate your current holdings and suggest sensible choices that may help to increase your diversification. For example, many investors own stocks through a variety of managed portfolios, including mutual funds, IRAs, 401(k)s, variable annuities and variable life insurance. It is possible that these portfolios are over-concentrated in one or two industries or even a few stocks. In some cases, it can make sense to select different investments that reduce your concentration in one or more areas and increase your portfolio’s balance.
- How wise is the investment I’m considering today? All investments have their day. Investments that performed well in the past often fall out of favor in the future. The historical patterns that make specific investments attractive in one environment may not mean they’ll be attractive in another. Each investment should make sense on its own, as well as in an overall plan for portfolio diversification. Many investors make the mistake of “chasing” returns. A financial professional can help you avoid making this common error.
Mutual funds can be a good way to diversify, but there are other strategies that also offer access to different markets, asset classes and professional management styles. They include variable annuities, variable life insurance, and individually managed investment accounts. A financial professional can help you evaluate which strategies available for diversification may be right for you. Once your plan is in place, your financial professional can also help you monitor your investments’ performance and make the revisions you feel are appropriate over time.
Prepared by The Guardian Life Insurance Company of America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.