A Primer on Diversification
In a previous article “The Importance of Rebalancing” our Senior Investment Advisor, Kevin Jaegers, wrote about the importance of keeping your portfolio at the desired risk level by rebalancing. He mentions that to achieve your desired risk level you will have a portfolio that has a mix of cash, stocks and bonds, or a portfolio that is diversified. This week, I thought it would be appropriate to focus on diversification and to shed a little light on why this popular investment strategy is so important.
We have all heard the saying “don’t put all your eggs in one basket.” When it comes to investing diversification is essential, without it, you run the risk of losing a significant portion of your account’s value if a single investment fails. Your goal is to build a portfolio which will include different types of investments and different types of securities.
The purpose of diversification is to reduce your risk by allocating your account across several different market segments and position your account for long-term success. This does not mean that you simply select your mutual funds by random and call yourself “diversified.” Rather its means that you will establish your core choices (Large Cap, Small Cap, International, Bonds, etc.) and then allocate the appropriate amount to each investment for your risk level and your timeframe. In a properly diversified portfolio, the performance of all of your assets will vary and you will have some assets that go down and some that will go up or remain steady, but overall your portfolio has reduced volatility and risk.
An investor’s timeframe can be the most influential factor when diversifying your portfolio. Your timeframe is determined by how long you have until you retire and/or start taking withdrawals from your account. An appropriate portfolio for the investors with a short-term time horizon would have a greater percentage toward cash and bonds to lessen the volatility on the account; this need for a conservative portfolio is because when the time comes to take a withdrawal your account is positioned where market fluctuations will have a smaller impact on the value of your account and your ability to make adequate withdrawals. Longer timeframes provide an opportunity to invest a majority of the portfolio into stock funds because you are able to look beyond short-term market movements and the years of high returns balance out periods of low returns. With a longer time horizon periodic (short-term) market fluctuations become less important. A well diversified portfolio will likely have less volatility and steadier returns over the long-term than an undiversified portfolio.
When it comes to investing, everyone’s situation is different and is influenced by many factors. It is important to determine your situation before making any investment decisions. You will first need to decide what type of investor you are and what type of portfolio will be appropriate for you. If you find yourself struggling with this step, it is important that you get some help (feel free to contact us with any questions or comments or you can get started and register with Smart401k). Always remember that the market will go up and the market will go down, but if you keep your portfolio properly diversified you can give yourself an opportunity to benefit from long -term growth in the market while also reducing the overall volatility and risk in your portfolio.
Jessica Slaters, Investment Advisor
July 24th, 2008 at 12:35 pm
Hi, I am a young adult (27 years old) who is starting to pay more attention to my investments. Does being young mean I should have an aggressive portfolio?
August 6th, 2008 at 9:02 am
Good question. In my opinion, one of the most important things (and perhaps hardest) in investing is building a plan that balances your risk tolerance (e.g. your ability to handle psychological or emotional impact of the invariable ups and downs in the market) and an investment strategy, and the risk associated with it, that enables you to achieve your retirement goals.
As a young investor, only 27, you likely have more than 30 years until you will retire. This timeframe means that you can take advantage of the long-term returns of the market, ignoring the short-term bumps, by pursuing a more aggressive investment strategy (e.g. more stocks and less bonds). When you are deciding how to invest it is important to consider how much time you have until retirement, how much risk you are comfortable with, what your goals are for retirement and how much you have already saved. In addition, it is important to be appropriately diversified across different asset classes (i.e. large cap growth, small cap value, etc). If you need help deciding what type of portfolio is appropriate for you it is always ok to consult an advisor about your investments.