Diversification in many forms
By Gary Silverman, CFP®
As several of my previous columns have mentioned, diversification is one of the hallmarks of a well-balanced portfolio—having growth to get you to your goal without making you ill in the process.
Diversification takes on many forms. First, we want to make sure that a disaster befalling a single company will not undermine your portfolio. That is why you should never put too much money in any single stock, bonds of a single company, or other investment tied to the fortunes of a single firm. This is also why most people should use mutual funds and exchange-traded funds almost exclusively. These pooled investments hold securities from dozens, if not hundreds, of different companies.
Next, you don’t want to have too much of your money in a single investment sector. In the year 2000, the technology sector made the prudence of this approach clear. In 2001, airlines felt the sting of 9-11. In 2008 the anemic performance of real estate, auto, and financial stocks made this wisdom very obvious yet again.
One step up from sectors are asset classes. The main ones are stocks, bonds, cash, real estate, and commodities. By properly mixing investments from more than one of these types of investments, you are protecting against large economic events decimating your entire portfolio. This is pretty obvious with even a casual study of the stock market in 2008. If you had balanced your stock holdings with those of fixed income investments like bonds, you would have dramatically reduced the losses in your portfolio.
Another area of diversification is global. The United States generates less than one-quarter of the global gross domestic product (GDP). This is pretty good for a country with less than 5% of the world’s population. But we are not the world. Perhaps more importantly, while U.S. and foreign markets act similarly to global events, they do not react identically.
Certainly political and currency concerns need to be taken into account, but with over three-quarters of the world’s GDP happening outside of the United States, do you really want to ignore the rest of the world?
While we diversify to raise returns and lower risk, it does have its drawbacks. You will never have all of your money in the investment that does best any particular week, month, or year. So when stocks are in a bull market, any money you have outside of stocks is going to make your portfolio underperform. If the United States has the best market performance then any money diversified into foreign investments will be a downer. Yes, diversification will keep you from making a killing on any specific investment.
This doesn’t mean that you are doing anything wrong. After all, for a long-term goal, you are not trying to design the best investment mix for today or even this year. Your goal is to design a portfolio that will meet your goals across time, starting now until you need to spend the money.
This article was published in the Wichita Falls Times Record News on May 3, 2017.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.