You’ve probably heard the saying “don’t put all your eggs in one basket”. It’s a simple warning that’s easy to understand: if you put all of your eggs in one basket and then something happens to the basket, you have now lost all of your eggs! Applying this idea to money: would we put all of our money in one place? We wouldn’t. This is where portfolio diversification comes in.
If you have not already read our post on the methods of constructing an investment portfolio, you can click here to learn more.
What Exactly Is Portfolio Diversification?
Diversification reduces risk by allocating investments and assets among various financial instruments, industries, and other categories. In other words, dividing the eggs amongst a variety of baskets made out of a variety of materials and carried by a variety of different people.
The best way to diversify your portfolio is to spread your investments around among multiple different types of securities.
There are two major types of investments you should consider to achieve a diversified portfolio:
Stocks
Almost all of our clients come to us with an understanding of – and experience with – the stock market, which is a great place to start your diversification journey.
Stocks are a unique investment for several reasons: they are potentially the riskiest investments you can make, and they will also be the most aggressive portion of your portfolio. The volatile nature of stocks has the potential to make or break your portfolio, so use them wisely.
A word about foreign stocks
Domestic stocks not risky enough for you? Try investing internationally. International stocks are a completely different ball game than domestic stocks and should be treated as such. They generally hold both a higher potential for risk and returns.
Bonds
Bonds are typically less volatile than stocks and have the ability to generate a steady income of interest.
It is very, very highly recommended to invest in both stocks and bonds, as bonds usually react differently to changes in the market than stocks do. Meaning, if you have a horrible day in the stock market, your bonds might be doing alright.
Your comfort level with risk will likely determine whether you favor stocks or bonds. Bonds tend to provide more long term, steady results. Stocks generally offer higher returns, but – of course – at a greater risk.
Other options
Of course, there are other investment opportunities.
Short-term investments (such as money market funds and certificates of deposit) can be good options for conservative investments.
Determining how to allocate assets is influenced by a variety of factors including risk tolerance, age, time horizons, and goals… but we will get into those in the next few blogs.
Why Should I Diversify My Portfolio?
The purpose of portfolio diversification is risk management. A clearly considered risk management plan is important to have in place when making decisions about how to allocate assets.
You can learn more about understanding the factors around risk in our previous blog “What Actually Is Risk in Investments?”
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.
Let’s be clear: the main goal of diversification isn’t to get the highest payout; it’s to keep your portfolio safe. In other words, to lessen the impact of risky investments that didn’t pan out. This definitely takes some thought, and in our opinion, seeking out some expert advice is a good idea.
To successfully diversify your portfolio, you have to thoroughly think about your comfort level with risk, financial situation, investment goals and more. Either way, it is wise not to invest too heavily in any one particular security.
Can Overdiversification Hurt Investment Returns?
Having too many baskets for your treasured eggs can also be a problem.
In the case of portfolio diversification, the idea that more is better isn’t always true. Over diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk.
This is a lot to consider. How do I create a balanced portfolio?
Although the concept of portfolio diversification is a straight-forward one, creating a diverse portfolio might seem overwhelming. It’s a basic concept to understand but many investors can make catastrophic mistakes with too much concentration on a few assets while others settle for average performance because of overdiversification.
Saddock Wealth is here to help. Our devoted team of wealth management experts will support you and your family step by step in creating a risk management plan that you feel confident about, as well as a diverse portfolio that speaks to your unique needs.
We are dedicated to getting to know you, your goals and your risk comfort level. We aren’t interested in chasing the next trend – our approach is a holistic one based on our experience in navigating the highs and lows of the market with our clients for over three decades. You’ve worked hard for your money— it’s time for it to work hard for you!
Schedule a meeting with us here.