An easy-to-understand description of the investment term “diversification” is “not putting all your eggs in one basket.” In other words, spreading your money around. By placing money in different asset classes (e.g., stocks, bonds, and cash-equivalent products such as certificates of deposit and money market funds) and different products (e.g., mutual funds and exchange-traded funds) within each asset class, investment risk is reduced.
A diversified portfolio has less volatility (i.e., price swings) than if you put all of your money in one place. For example, over the long term, foreign securities may “zig” (e.g., increase in value) when U.S. securities “zag” (e.g., decline in value). Diversification can be done very simply by all investors. It does not require a degree in finance or a financial advisor on retainer.
Below are six simple investment diversification strategies:
• Consider purchasing mutual funds, unit investment trusts, and/or exchange-traded funds that are already well diversified. Each of these investments contains professionally selected securities of a similar type. An example is a municipal bond fund that contains a portfolio of investment grade (rating of BBB, A, AA, and AAA), long-term tax-exempt municipal bonds. Typical stock mutual funds contain stock issued by over 100 companies. This reduces investment risk in the event that several individual companies within the mutual fund portfolio fail.
• Don’t forget index funds, which are often even well-diversified than actively-managed (non-index) funds. Many index funds contain several times more securities. Index funds consist of securities within a benchmark market index such as the Standard & Poor’s (S&P) 500. For the best diversification potential, look for index funds that track a broad-based index. Examples include the S&P 500 (used to track the performance of large U.S. company stocks), Wilshire 5000 (used to track the performance of all U.S. company stocks), and EAFE Index (used to track the performance of international securities). A major advantage of index funds is their low expenses because the index fund portfolio is “pre-selected” to include securities contained within a specific index.
• Ladder fixed-income securities such as certificates of deposit (CDs) and bonds by making purchases with staggered maturity dates. For example, buy five $1,000 bonds or CDs with different maturity dates instead of one $5,000 bond or CD. Laddering allows investors to access their money (investment principal) more frequently and benefit from changes in interest rates.
• Don’t overdo it. A maximum of six to eight mutual funds is usually plenty. Any more and the “paperwork” (e.g., quarterly statements and income-tax related forms) gets unwieldy. You can also become a “closet indexer” when you own a slew of mutual funds. This means that you own enough mutual funds to actually mirror a market index, but lack the low expenses of index funds.
• Select a variety of industry sectors (e.g., transportation, utilities, health care, and technology) that are affected differently by economic events. For example, if oil prices rise, oil companies profit but airlines and trucking companies that use great quantities of fuel see their profit margins erode.
• Diversify with time. As an investment’s holding period increases, investment risk due to market volatility lessens. Also be sure to rebalance your investment portfolio periodically to maintain its original assets weightings (e.g., 50% stocks, 40% bonds, 10% cash assets). Otherwise, it will become more heavily weighted toward one asset class (e.g., stock) over time, which increases investment risk.
