By Ruth Mahoney, President, Capital Region, KeyBank
Diversification is simply the “act of introducing variety.” Diversifying your investment portfolio does just that, adding a variety of investments that will allow you to take a little risk with some investments while playing it safe with others.
In the short-term, diversified investments do not yield big results. Nor are they designed to net you the largest possible return on investment possible. Instead, being diversified is about having a variety of investments that balance each other out over the long term to yield positive, safer returns. For example, investing heavily in one sector of the economy or a hot business may yield great returns if you time it right, but if that market stagnates or declines, your exposure to risk and the potential to lose big money is both real and likely. Diversification protects you against such market volatility.
Here is another example of the power of diversification. Between Jan. 1, 2001, and Nov. 30, 2011, Standard and Poor’s 500 Fund Index returned a 1.4 percent gain. According to Index Fund Advisors, investors with diversified portfolios averaged a 5.7 percent annual return during the same time period. While some asset classes purchased by diversified investors have suffered, as a whole, largely due to the strong performance of bonds, diversification has leveled the drops. Had investors only bought the best stocks of 2007 and held them in the 2008 market downturn, they would be down more than 60 percent, according to T. Rowe Price.
The benefits of diversifying your portfolio
With any investment, there are risks, including loss of money and price volatility. A diversified portfolio is not immune to these exposures. However, the benefits are many. A diversified portfolio will:
- Reduce the overall risk on your investment.
- Further reduce risk when the diversification is among assets with low correlations to one another.
- Limit losses.
- Account for the uncertainty of knowing which investments or asset classes will perform well or poorly or when.
- Protect your portfolio from events that you cannot foresee, such as a business bankruptcy.
- Maximize the odds that you will reach your financial goals when combined with a solid financial plan.
- The goal of a diversified portfolio is to select enough investment categories to keep the option of a lower return minimal—to better maintain your investment in hopes to see larger growth and maximized returns.
- Your allocation of investments should be largely based off of your financial plan. In other words, it should take into account your cash flow needs, investment goals, risk tolerance and when you think you may need to access the funds in the future.
Also, as your financial needs change as life events happen, you will likely review your financial plan and reset goals. When this happens, you should reevaluate your investment portfolio and account for these changes.
A deeper understanding of diversification
An investment that performs well one month or year may not perform as well the next. For example, according to Charles Schwab, emerging market stocks were the top-performing asset class in 2012 but have ranked toward the bottom every year since. Core bonds, which include Treasury bonds, agency bonds and mortgage-backed bonds, ranked near the bottom in 2012 and 2013 but toward the top in 2014 and 2015.
A diversified portfolio distributes investments across several different investment categories such as stocks, bonds, certificates of deposits (CDs), money market funds, mutual funds, exchange traded funds (EFTs), real estate and/or other asset types so that your money isn’t all in one place. This is a strategy to combine a variety of assets to reduce your overall risk.
How you diversify your portfolio should account for a variety of factors, such as your age, income streams, and risk tolerance. Diversification, while a sound strategy for all, is not a one-size-fits-all, and spending the time to determine which ratio is right for you will pay big in the future. And while the perfect balance is hard to achieve, a diversified portfolio coordinates investments that fluctuate in value at different times so that the overall investment can increase in value.
As an investor, it’s natural to want to maximize the return on your investment. However, you should avoid succumbing to the temptation to invest all your money in the hottest stock available. Sure, the reward could be huge, but it isn’t a sound approach because you are just as likely to lose everything as you are to hit the investment lottery. If you do want to be more aggressive and have a higher tolerance for risk, there’s a way to do it. Pair “risky,” high-return investments with “safer” investments that deliver lower, more predictable returns. This will help create a balanced portfolio that performs more steadily.
Just as you should evaluate your financial plan regularly, you should review your portfolio regularly, especially as you get older. What works when you are young and graduating college may not work as well when you start a family or change jobs. And as retirement nears, it’s important to shift money into asset classes that may not be as risky. The key is to find the right level of diversification for you. Contact your financial advisor if you need help creating or adjusting your portfolio.
About the author: Ruth Mahoney is president of KeyBank’s Capital Region. She may be reached at either 518-257-8619 or [email protected]. This material is presented for informational purposes only and should not be construed as individual tax or financial advice. Please consult with legal, tax and/or financial advisors. KeyBank does not provide legal advice. ©2016 KeyCorp. KeyBank is Member FDIC.
Understanding the different investment options available to you
A variety of investment options are available that can help you build a diversified portfolio that meets your short- and long-term goals. Let’s take a deeper look into some of these investment vehicles:
Stock – A type of security that signifies ownership in a company and represents a claim on part of the company’s assets and earnings. A holder of stock (a shareholder) has a claim to a part of the company’s assets and earnings. Stocks are bought and sold electronically through stock exchanges such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ).
Bond – A debt investment in which an investor loans money to an entity (typically corporate or governmental) that borrows the funds for a defined period of time at a variable or fixed interest rate. In other words, they are loans where you serve as the bank. You loan your money to a company, a city, the government and they promise to pay you back in full, with regular interest payments. Different types of bonds include government, corporate and U.S. treasury bonds.
CDs and money market funds – A certificate of deposit (CD) is a savings certificate with a fixed maturity date, specified fixed interest rate and can be issued in any denomination aside from minimum investment requirements. You can’t just withdraw money whenever you would like. A money market fund, on the other hand, keeps your money liquid while earning you interest. A money market fund’s purpose is to provide a safe place to invest easily accessible, cash-equivalent assets. Money market funds are a low-risk, low-return investment. Both are good ways to put your cash to work to make you more cash.
Mutual funds – Made up of a pool of funds from many investors that buys stocks, bonds or other securities. If a mutual fund is part of your portfolio you will have access to all the investments in that fund. This is a good option for diversifying your portfolio.
Exchange traded fund – An ETF is an investment fund traded on stock exchanges, much like stocks, but it holds assets such as stocks, commodities or bonds much like a mutual fund. ETFs may be attractive as investments because of their low costs, tax efficiency and stock-like features. An ETF combines the valuation feature of a mutual fund or
