About diversification
Diversification means spreading your money over a variety of investment opportunities instead of betting the bank on one potentially high-flying stock. Diversification is designed to smooth out the impact of rapidly changing markets on your portfolio. In fact, once you've diversified your investments, you might rest a little easier, knowing your portfolio may be less susceptible to wild economic fluctuations than a single stock or investment class might be.
Best of all, diversification doesn't have to be difficult.
Take mutual funds. They're inherently diversified because they contain a variety of investments. But each fund is different from the next one and, accordingly, carries a different level of risk. As a result, many prudent investors spread their investments across three broad asset categories: stocks, bonds and stable value instruments.
Stocks often get more attention than the other asset categories, but bonds and stable value instruments are also popular with many investors. Let's review the options:
Stocks
When you own stock, you own a part of a company. The risks can be high, but so is the potential for return.
Bonds
Bonds are the IOUs of the investment world. Businesses and governments issue bonds and promise to return your principal to you plus interest. The risks are generally lower than stocks and so is the potential return.
Stable value instruments
Money markets, usually viewed as having "stable" or steady returns, fall into this category. Such funds are considered less risky than either stocks or bonds. But lower risk has its price; in the case of money market funds, the long-term potential return is lower than either stocks or bonds. (An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such funds.)
Some mutual funds contain elements of all three categories. A blended fund may contain stocks, bonds and stable value instruments. The exact mix of holdings in a blended fund may vary from month to month depending on whether the fund's managers see a brighter future for stocks or bonds.
Diversification and stock funds
Why do stocks dominate the business news? Maybe because there are so many different types of stocks -- large company stocks, small company stocks, stocks of technology companies, healthcare organizations and more. Or maybe because the potential returns may be greater than bonds or money markets. Here again prudence suggests diversification, holding more than one type of stock fund. Growth stock funds hold companies with the potential for big earnings or increased revenue. Value stock funds hold companies thought to be undervalued by the market.
In any case, with more than one stock fund -- or bond fund, for that matter -- you have a better chance of seeing one part of your investment increase when another part is decreasing. After all, what goes up, historically, usually comes down, at least from time to time. But it's difficult to know when an investment has peaked or hit bottom. That's why diversification makes good sense.
When the next downturn arrives -- whenever it arrives -- your decision to diversify could turn a terrifying free fall into a more acceptable setback.
Diversification and you
So, it turns out diversification is pretty simple. You just need to hold a little bit of everything -- using funds that hold stocks, bonds and money markets -- right? Not quite -- instead, you need to hold investments that match your particular goals. And your goals can vary depending on your age, your accumulated wealth and your inclination to take greater risks for potentially greater returns.
Time for a little self-assessment: Are you just starting out in your career? Somewhere in the middle of it? Or close to retirement? Are you a saver, always in favor of reducing risks? A trader, ready to jump to the next great idea as soon as the old plan falters? Or an investor, someone who views investing as a long-term activity? Your location along life's journey and your comfort level for risk can make a difference in the design of your specific diversification plan.
Let's take a look at a few examples of personalized portfolios:
New kid on the block
Young investors with small investment accounts generally feel more comfortable taking risks if those risks come with the potential for greater returns down the road. As long-term investors, they know that interest rate changes come and go, and that, even though the past is no guarantee of future results, the stock market has historically provided positive returns. Not surprisingly, many New Kids build portfolios composed entirely of stock funds.
Middle of the road
People in their 30s and 40s often tend to incorporate bond and/or money market funds into their investment portfolios. They like having their money in stocks, but they also appreciate the lower risk of other investment vehicles. And they count on the power of compounding to add to their retirement nest eggs. Younger, more aggressive Middle Roaders might build 60/40 portfolios: 60% stocks, 40% bonds. Investors who are closer to retirement often turn the percentages around and hold 40% stocks and 60% bonds.
Asset preservationists
People who are retired or close to retirement tend to "play it safe," especially when compared to New Kids. They realize that stocks can rise and fall dramatically, and they're also aware that they have less time to recover from market losses. Often, the pleasure of watching stock prices rise is overcome by their dissatisfaction when prices fall. As a result, this group tends to favor bonds and money market funds more highly than stocks, often removing stocks from their portfolios entirely.
Keep in mind that these are only examples. For instance, some New Kids like to include bond funds in their portfolios. They know the power of compound interest helps them more than older investors, so they look more favorably on "low-powered" investments that carry less risk. At the other end of the scale, some Asset Preservationists keep some of their money in stock funds. In recent years, they have benefited from their participation in the stock market, even if their portfolios were heavily invested in bond and money market funds.
In short, the best diversification strategy for you is the one you're most comfortable with. Form a plan that makes sense to you, and keep in mind your comfort level when it comes to risk. Most of all, remember you're investing for the long haul. You don't have to keep your finger on the pulse of the market all the time, unless, of course, you're invigorated by all the hustle and bustle.
After all, there's more to life than investing.