Why Diversifying Your Portfolio is Important
Volatility returned this week as the Federal Reserve made the decision to cut rates by a quarter point. This sent ripples through the market, though we believe this to be a temporary shift in markets. In the short term, markets are a voting machine where they price in any and all available data almost as soon as it is available. In the long term, they're weighing machines. They care about things like corporate earnings and company growth. So what can you do to combat this volatility, embrace it, and use it to your advantage?
If you’re an investor, whether novice or expert, it’s likely you’re concentrating on building your portfolio if you're new and maintaining your portfolio if you've been investing for some tie. But as important as it is to build that portfolio, you should also ensure that it’s diversified.
Why is a diversified portfolio so important?
There are three key reasons why diversifying is important:
- As many of you know, diversified portfolio helps minimize volatility risk and risk of loss. Stocks can be a risky investment at any time, but with a diversified portfolio, you can help minimize that risk by spreading it among a variety of investments.
- Diversifying can also help investors maintain capital. Catch that? It can help you protect principal. Someone purchasing stock at the age of 50 has a much different investment goal than someone age 65 who is entering retirement. For older investors, it may be much more important to increase capital to keep pace with the costs of rising healthcare, while it may make sense to grow capital very aggressively in the accumulation phase for a 50 year old.
- You’ll have a much better chance at generating growth if your portfolio of stocks is diversified. Often times, the losers are offset by the winners, and By having a significant investment in both, you’ll help to offset any potential losses from underperforming stock.
It’s also common for one particular type of asset to perform better over a specific period of time, depending on external factors such as
- Current interest rates
- Currency markets
- Current market conditions
The trick is understanding which asset class may or may not be the one that outperforms the other, and it can certainly be frustrating to make the wrong call. We always advise clients to remain humble, and realize they will not always make the right decision, and we never admit to making the right call anytime. Instead, we ask clients to embrace failure instead of shunning it, as it is just a part of investing. Period.
But it’s also important to remember that while one investment may be outperforming others, the standard is that there is no particular investment that will continually outperform others over the long term. This is why we believe in an actively managed approach.
But what is a diversified portfolio?
A diversified portfolio is one where investments vary, with exposure to one particular type of asset is limited. Diversifying can look like two very different things to young investors and those nearing retirement age. Young investors are much more likely to be comfortable riding out the peaks and valleys of their investment portfolio, while investors nearing retirement age are more likely to be interested in slow growth and a more consistent performance without the volatility that more risky investments may face.
In order to truly diversify your investment portfolio, many professionals recommend that your portfolio consists of the following:
- Domestic & Foreign Stocks (or ADRs). Stocks are perhaps the most volatile investment in the short term, but they also represent the highest probability for growth. Short term investment in stocks carries the biggest risk of volatility, but stocks can also provide the biggest reward if they are held on to for a significant amount of time.
- Bonds. Considered less volatile than stocks in the short term, bonds can provide a shield against market instability created by stock investments. What most people don't know is that bonds carry higher volatility risk in the long-term since they have longer market cycles than do equities, and thus have longer bear markets.
- Money Market Investments. While ultra-conservative, money market accounts and similar investments such as a short-term CD can provide stability and "safety" that other investment options may not. However, we believe these should be used almost solely for hyper-short term investments, as inflation risk and opportunity cost is often far to great of risks for the longterm.
- International Stock. International stock can provide a higher return than their U.S. counterparts, but they can also carry a higher risk. However, for those looking to diversify their portfolio, international stock can be a good addition.
The key to diversification is to find the right balance between risk and stability and add positions accordingly. Theoretically, this allows you to reach your goals while also worrying less.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Focus Asset Management with Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2019 Focus Asset Management & Advisor Websites.