So you’ve opened an account with a stock broker. What’s next?
Some say that we should spread our eggs across many baskets. Some say that we should put all our eggs in just one basket… and watch it carefully. So which is the best advice?
Unless you have the luxury of being able to watch a single stock position like a hawk, or have your automated stop order watch it for you, the first piece of advice is the one you should take notice of.
Put your eggs in many baskets!
In a nutshell, here’s what diversification stands for:
It’s a portfolio strategy in which you spread your money around among different investments in order to reduce the risk of loss from a decline in the investments. Its goal is to reduce the risk in a portfolio. When diversification is properly applied, then it is expected that volatility or fluctuations in portfolio value become subdued and limited. The act of diversification reduces a portfolio’s swings as well as both upside and downside potential, thus — and I like this statement — allowing for more consistent performance under a wide range of economic conditions.
That said, I’d like to list the different ways you can actually diversify to control that so-called market risk:
Different Diversification Strategies For Your Portfolio
#1 Diversify across asset classes.
Remember that it may not be enough to hold separate positions in different stock indexes. Why? Because many of those indexes may tend to rise and fall at the same time, which is why it’s a good idea to throw a lot more asset classes such as some commodities, bonds, property and cash, and other assets into the mix. Therefore, the most common way to diversify is according to asset classes. When you employ an asset allocation strategy, you are controlling the level of risk that your money is exposed to since your funds are spread around across different forms of equities, bonds, cash and hard assets.
Some common asset classes include:
* government bonds
* corporate bonds
* cash equivalents
* real estate
You can easily achieve diversification this way through mutual funds, index funds and target date funds.
#2 Diversify across asset class variants.
Within each asset class, you can practice further diversification. For instance, equities have many representations in the mutual fund world. Variants or subclasses refer to more granular characteristics of the asset class. Here are some examples:
Equities can vary according to:
* the size of companies represented in a “basket” (e.g. large vs medium vs small cap stocks)
* the way the stocks’ prices move as the stocks chart their growth (e.g. growth vs value stocks)
* the geographical market in which the stock moves (e.g. domestic vs international)
Bonds can vary according to:
* their maturity dates (e.g. short term vs long term bonds)
* their level of risk (e.g. junk bonds, anyone?)
* who issues the bond (e.g. government vs corporate)
* how they pay out
Cash vehicles vary mostly according to rates of return and level of security offered, which are usually characteristics that are inversely proportional to each other. Generally, within the investment world, the higher the rate of return, the less stable the fund value is expected to be.
Note though that most of the time, you don’t really need to seek this kind of detailed representation to achieve a well diversified portfolio, as positions in basic asset classes may be sufficient to lower your market risks.
#3 Diversify across securities or investments within each asset class
If you are buying mutual fund shares, then you are effectively diversifying across securities. By buying into a basket of securities via index funds, mutual funds, ETFs, managed funds and such, then you are automatically spreading your risk across the board.
#4 Diversify across industries and sectors.
If you are interested in following a particular sector or industry but do not want to put all your eggs into one company’s stock, you can buy sector funds that specialize in a specific industry or stock group, such as financial stocks, gaming stocks, internet stocks, semi-conductor stocks and the like. You’re diversified within a group, but still fairly concentrated within a sector.
#5 Diversify across financial institutions and fund families.
There are many financial institutions and companies out there, from discount brokers to mutual fund companies, banks and even insurance companies — all offering financial and investment products. But no institution is perfect. Your non-cash investments are not FDIC insured, so entrusting them to any one institution holds some risk, no matter how minuscule. Banks and institutions have folded in the past, and have been rocked by scandal on occasion. So it’s something to keep in mind when you’re putting your money on the line. There’s a tradeoff between desiring the convenience and organization of a consolidated portfolio in one location versus deploying your funds across various companies, or placing your eggs among various financial baskets on the Kiplinger’s list of “favorite fund companies to buy into now”.
#6 Diversify across fund managers.
Again, when you invest in various mutual funds, you are normally giving your money to different fund managers to invest. But it’s not all too uncommon for the same people to be simultaneously heading multiple funds, as in the case of the same managers used for various international or foreign based funds in the same institution.
#7 Diversify across time horizons and levels of liquidity.
Based on your various goals, it’s a good idea to maintain different levels of liquidity. For your short term goals such as funding a big ticket event (e.g. wedding or travel), you’re typically going to save using a cash account. For medium term goals, you can take some risk with blended funds for example, while for the longer term goals (e.g. kids’ college fund, retirement) you can be less liquid, by getting into more aggressive stocks or real estate.
#8 Diversify across time with dollar cost averaging (DCA).
When do most people decide to throw a lot of money into the stock market? Is it when it’s the best time to do so — for example, in March 2009 when the market was scraping the floor? No, it’s when they find themselves with a large cash pile from an unexpected inheritance, severance package or house sale.
Suppose you had received your windfall payment in October 2007 and had ploughed it straight into the S&P index fund all at once, just as the advisor advised. Could you have sat tight through the 55% fall without selling out at exactly the wrong time just before the inevitable recovery began?
It is for this reason that some financial advisors suggest pumping your funds into the markets gradually over time using the process known as dollar-cost-averaging; the idea being to lessen the potential effect of sheer bad timing.
Dollar cost averaging means investing a same-sized amount each month, let’s say $500 per month, on the basis that this fixed installment buys you more fund units or equity shares when the price is low and fewer when the price is high. So you don’t have to time it right. Dollar cost averaging is a form of diversification over time.
One of my favorite diversification mechanisms is by investing periodically across time. By buying stocks on a regular basis, you end up picking up stocks at a variety of prices as they fluctuate. In this case, if you’re not confident about the market’s movements, you may want to distribute your purchasing power throughout a specific time period.
But be aware that some financial advisors recommend this approach in order to secure a regular commitment from those clients who simply don’t have a lump sum to invest at the outset. Also, we should note that there have been strong arguments that investing a lump sum in one fell swoop actually results in better returns compared to a DCA strategy. Historically, with markets marching higher, it turns out that you may be sacrificing a bit of your returns for that sense of “security” or assurance that you’re not buying all at once at the “wrong time”.
Asset allocation accounts for 90% of your return while individual securities and market timing will account for the other 10%. By diversifying, you can reduce risk for up to 70% of the total risk received by a non-diversified portfolio or pure/concentrated position. So take precautions and practice reasonably diversified investing!
Created June 1, 2007. Updated October 31, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.