Who doesn’t like that rush of adrenaline when you make a big bet and it pays off? Level-headed investors, that’s who.
In real life, outside of the overly air-conditioned, alcohol-infused cocoon of a casino, concentrating your investment money on a single stock, sector or asset class is just the same as gambling. Sure, you get the same rush when your chosen investment goes on a tear. But if it goes the other way, if the marble lands on red and you bet the farm on black, it’s not just your discretionary money on the line. It’s your entire portfolio.
When seasoned investors see one of their investments skyrocket, be it a single stock, a mutual fund, or a concentration of investments in a particular sector, the celebration is subtle and short-lived. Similarly, when something in their portfolio goes into a death spiral, the mourning period is also brief.
That’s because they manage their portfolios in a way that ensures that if one of their holdings starts moving in a direction they didn’t anticipate, the results are not financially devastating. They’ve got other investments in the portfolio to counterbalance that loss. In other words, they’re properly diversified.
Balance Your Returns
Diversification helps smooth your returns over time. The act of diversifying simply means placing lots of bets on different kinds of investments to ensure that your portfolio isn’t too tied into the success or failure of any single investment, asset class or style.
You’ve heard the whole “don’t put all your eggs in one basket” slogan. Well, to continue our Vegas metaphor, it’s better for your overall long-term returns and near-term digestive system to put your poker chips in many baskets. When you are properly diversified and one type of investment tanks, there’s another investment that soars and keeps the balance.
Read: Here’s Why You Should Start Investing Now
On average, a portfolio should be rebalanced four to six times per year. However, if your portfolio isn’t rebalanced regularly, diversification will become less effective.
Stay in the Game
When faced with seismic events in our portfolios, most investors have a very human and very understandable reaction: They hit the panic button.
This panic triggers some pretty self-destructive behaviors, such as selling off the investment, triggering taxes and fees, or giving up on investing altogether and shoving their savings in a low-interest savings account.
Related: 6 Things Warren Buffett Says You Should Do With Your Money in 2015
Perhaps even more dangerous to your long-term returns are the gradual drifts that make your portfolio grow or shrink unevenly. Then one day, when you bother to look, you’re shocked to see that 25 percent of the value of your portfolio is concentrated in a sequin manufacturing company based in Greece.
To protect yourself from seismic events or gradual shifts (or a sudden sell-off of sequined garments), it’s important to review your portfolio at least quarterly to see if anything has been thrown out of balance.
There are two sure-fire ways to know when it’s time to re-balance:
- When your assets drift outside their target allocation. You want to ensure that the investing plan you originally put in place is still intact and positioned to deliver steady long-term gains.
- When life events alter your investment profile, risk tolerance, or you’re going to need the cash for a near-term expense. The closer you get to the point when you need the cash, say for retirement income, college costs or a big expense like a down payment on a home, the more money you need to move into safer havens such as bonds or cash equivalents.
Five Ways to Get Diversified
These are factors that the pros use to measure a portfolio’s true diversity:
1. Asset Classes
Stocks, bonds and cash alternatives are the three main asset classes. Real estate and commodities, like gold and coal, are sometimes included. The biggest difference between them is volatility, or risk levels, determined by how much exposure each has to forces that affect the returns they earn. While stocks typically carry the most risk, they offer the greatest growth potential. Because bonds are less volatile, their returns are not as great but they can provide helpful stability in turbulent times. Cash alternatives carry the least amount of risk and therefore deliver the lowest returns.
2. Industry Sectors
Firms are grouped into different sectors of the economy such as technology, manufacturing, pharmaceutical and utility companies. There are different ways to invest in different industries: buying stock in an individual company that operates in that industry; buying a mutual fund made up of many companies in a particular sector; or buying an exchange-traded fund (ETF) that, like a mutual fund, concentrates its holdings on a narrow sector of the stock market.
3. Market Capitalization
This is the total value the market places on a company and its assets. Firms are considered to be large-cap, mid-cap or small-cap, based on the dollar value of their outstanding shares of stock. Certain characteristics are typically assigned to stocks in one market cap category or another. So depending on your investment objectives, you might be drawn to invest in one of the categories over the others, or, better yet, invest a portion in each.
4. Investment Styles
Wall Street often classifies stocks as value or growth. When a mutual fund indicates that it is a growth fund, that means that it invests in companies that the fund managers believe will grow faster than average. Value funds, on the other hand, seek to invest in businesses that are fundamentally sound, but that fund managers believe are trading at a lower price that does not reflect the company’s true worth.
5. Geographic Areas
The U.S. isn’t the only game in town open to investment. Just as you don’t want to be overly dependent on a particular sector’s performance, the same goes for any single country. Investing in companies, funds or ETFs that concentrate on business in different geographic regions reduces the risks associated with exposure to external factors like economic instability, natural disasters and civil unrest.
If you haven’t taken a look at your portfolio through the lens of diversification lately, it’s time. If you find that your cocktail of investments hasn’t been shaken since you last checked, then you can sleep better at night knowing that your investing plan has not veered off course.
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