Your portfolio doesn’t have to be overwhelming or complicated, and you don’t need a Ph.D. in finance to build one.
Diversification is a strategy anyone can use. I might mention a few numbers along the way – but don’t get overwhelmed. We’ll take it one step at a time. So, let’s get started and see if we can answer the question, what exactly is a diversified portfolio and how can I build one?
Diversification, according to Investopedia.com is defined as “A risk management technique that mixes a wide variety of investments within a portfolio.”
A common analogy to diversification is “don’t put all your eggs in one basket.” Essentially, diversification helps you reduce your portfolio risk. It can also increase the predictability of your returns. Before I explain why it’s a predictable measure, let’s talk about asset classes first.
Again, if we refer to Investopedia for the definition of asset class, it is “A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.” An example would be the largest companies grouped together based on their size.
All the large companies would be grouped together in one asset class called large-cap. While all the small would be grouped together in another asset class called small cap. You can group together alternative types of asset classes like real estate or commodities.
Now that you have an understanding of diversification and asset classes we can talk about actually diversifying your portfolio. Finding the right mix for your portfolio depends on your risk tolerance, time to goal and tax status. The correct mix is going to be dependent on your particular situation. This is because we’re trying to figure out what rate of return you need to achieve in order to get to your specified goal. If you save more or less and change your target date these factors will all affect your overall outcome.
You can choose one of the asset allocation models provided by your employer plan or company that holds your investments. It will be like buying a suit off the rack because while it fits and gets the job done, it’s not perfect. Getting a financial plan would be a custom fit to your financial life.
Asset Class Selection
Once you have the correct asset allocation model choosing your positions is rather simple. Typically there are not an extraordinary amount of options in your retirement plans. Most of the time we have found only one or two choices for each asset class in your portfolio. Unfortunately, the data that is presented only shows the rates of return on the 3, 5 and 10-year averages. It’s unfortunate because it can be very misleading when choosing which positions are right for your portfolio. Most of the battle is going to be choosing your asset allocation model as it relates to diversification.
Is diversification right for you?
Diversification works well if you’re willing to save, stay the course, and rebalance consistently. It’s not a swing for the fences, home run hitter strategy. Because the basis for diversification is owning various asset classes you can ensure that you will not outperform the top asset class nor will you lose like the worst either.
Diversification may help to reduce the highs and lows in your portfolio. If can help control the emotional rollercoaster that comes with investing in the stock market. It’s by no means a guarantee you will reach your goals or wash away all your investment fears.
One last point about diversification that I found rather interesting was on the SEC’s website. The Securities and Exchange Commission refers to it as “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.”
Diversification can help to increase the predictability of your portfolio and your goals it’s not the end all be all. Taking a look at various investment strategies is important in your due diligence. Speaking with a professional advisor can’t be stressed enough.