As an investor, do you have a difficult time understanding — or implementing — diversification?
If so, you aren’t alone.
When I used to work as a financial advisor, diversification was one of the hardest concepts to convey to my clients.
The idea is simple: “don’t put all your eggs in one basket.” Implementing that strategy, however, is harder than you think.
When you’re invested in something that’s doing well, your instinct is to invest more in it. After all, why fix what isn’t broken? When everyone is doing something, it creates hype and you may think that if you don’t get involved, you’re going to miss out on something big. That’s human nature. Unfortunately, in investing, human nature is dangerous.
When the herd mentality fails
If you’ve worked at a company for a decade or more, you’ve probably had a promotion or two and gotten pay raises. You have a 401(k) and you might be tempted to buy the company’s stock as well. Obviously it’s doing well if you’ve been there that long, right?
One name should dissuade you from that idea: Enron.
In every generation there seems to be an asset class that everyone raves about. It subsequently rises in value far quicker than the market as a whole. In the early 2000s, it was tech stocks. Anything with a dot-com name was getting bought up as if it were priceless. But we all know how that ended. Badly.
A more recent example was the real estate boom. Buying property was seen as a can’t-miss investment opportunity and profits were seemingly easy to come by. Everyday people were taking out second mortgages just to buy houses and flip them for a quick payday. That market ultimately collapsed in late 2008 and hit property values so hard that the real estate market still hasn’t completely recovered.
Investors can certainly make money by taking advantage of rising markets, but when everybody — even your harebrained uncle who knows nothing about investing — starts talking about “getting in” on the latest hot sector, it’s time to run the other way. Better yet, make sure all your “eggs” aren’t in that sector to begin with.
How should you diversify?
The hardest part of diversification is discipline. Maintaining the proper asset allocation is the ticket to long-term success in the market. You may already be familiar with basic allocation models, but diversification involves more than just splitting between stocks, bonds, and cash.
We can break down asset classes by what they contain and spread out risk more evenly.
Stocks are classified in a number of ways:
- Domestic or foreign: Diversifying across different countries is a good way of mitigating political and currency risk issues. It may not be obvious, but currency values fluctuate on a daily basis and can influence your overall returns. If you only invest in U.S. stocks and the dollar loses value relative to other countries, you will underperform in your portfolio.
- Market size: Stocks are categorized by overall value of each company’s stock offering. Large cap stocks are worth over $10 billion, mid-cap stocks range around $2 to $10 billion, and small cap stocks are under $2 billion.
- Sector: The stock market contains companies involved in every type of business imaginable and can be identified by what sector they’re involved in. It’s important to spread out your investments into more than one part of the economy to avoid bubbles like the aforementioned real estate and tech crash.Here’s a brief rundown of the different sectors available:
- Basic Materials
- Consumer Goods
- Industrial Goods
Bonds are classified in the following ways:
- Credit quality: A bond is assigned a credit rating that ranges from investment grade, AAA to BBB, or speculative which is anything with a BB or less. The yield or interest rate that you can get on a bond is primarily impacted by these ratings.
- Time to maturity: Bonds that get issued must be paid back in full at a later date. In return for buying a bond, you receive interest payments until the principal is returned to you. They are separated in three ways: short-term bonds mature in less than 5 years, intermediate-term bonds mature in 5 to 10 years, and long-term bonds mature in more than 10 years. The longer the maturity date is, the higher the yield offered is.
How to get diversification right
When starting out, buying mutual funds or exchange traded funds (ETFs) — especially index funds that track an entire stock market index or sector — is a good way to ensure some diversification. But even mutual funds aren’t as diversified as you think.
As your portfolio grows, you’ll want to analyze it to spot places you’re over- and under-invested. This can be complicated and may be more work that you want to tackle yourself. This is where financial advisors come in handy.
If you’re not ready for a financial advisor yet or prefer the do-it-yourself approach, Personal Capital is a free tool that provides a visual map of your portfolio and can help you determine what types of investments you need to load up on to better diversify.
Ready to diversify your portfolio? Use our resources to spread your assets out in the smartest way possible:
- 401k asset allocation: Two strategies for headache-free diversification
- Personal capital: Analyze your portfolio with this free app
- Index funds vs target date funds: How to decide which is right for you
Editor’s note: This article was originally published in February 2014. It has been thoroughly updated for relevance and accuracy before republication.